10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

(Mark One)

  x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the Fiscal Year Ended December 31, 2005

 

Or

 

  ¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission File Number: 0-19171

 

ICOS Corporation

(Exact name of registrant as specified in its charter)

 

Washington   91-1463450
(State of incorporation)  

(I.R.S. Employer

Identification No.)

 

22021-20th Avenue S.E.

Bothell, Washington 98021

(425) 485-1900

(Address, including zip code, and telephone number, including area code, of

Principal executive offices)

 

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes x    No ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes x    No ¨

 

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.   x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x    Accelerated filer   ¨    Non-accelerated filer  ¨

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act).  Yes ¨    No x

 

State the aggregate market value of voting and non-voting stock held by non-affiliates of the registrant as of June 30, 2005. $1,355,581,913.

 

Indicate the number of shares outstanding of each of the registrant’s classes of Common Stock as of January 31, 2006.

 

Title of Class


 

Number of Shares


Common Stock, $.01 par value   65,101,383

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s Definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 11, 2006, are incorporated by reference in Part III of this Form 10-K.

 



Table of Contents

ICOS CORPORATION

 

TABLE OF CONTENTS

 

         Page

Part I

        

Item 1.

 

Business

   1

Item 1A.

 

Risk Factors

   13

Item 1B.

 

Unresolved Staff Comments

   *

Item 2.

 

Properties

   24

Item 3.

 

Legal Proceedings

   24

Item 4.

 

Submission of Matters to a Vote of Security Holders

   25

Part II

        

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   26

Item 6.

 

Selected Consolidated Financial Data

   27

Item 7.

 

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

   29

Item 7A.

 

Quantitative and Qualitative Disclosures about Market Risk

   43

Item 8.

 

Consolidated Financial Statements and Supplementary Data

   44

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   *

Item 9A.

 

Controls and Procedures

   67

Item 9B.

 

Other Information

   *

Part III

        

Item 10.

 

Directors and Executive Officers of the Registrant

   68

Item 11.

 

Executive Compensation

   68

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   68

Item 13.

 

Certain Relationships and Related Transactions

   *

Item 14.

 

Principal Accounting Fees and Services

   68

Part IV

        

Item 15.

 

Exhibits, Consolidated Financial Statement Schedules

   69

Signatures

   84

* None


Table of Contents

PART I

 

Item 1.   Business

 

Overview

 

ICOS Corporation, a biotechnology company headquartered in Bothell, Washington, is dedicated to bringing innovative therapeutic products to patients. Through Lilly ICOS LLC (Lilly ICOS), our joint venture with Eli Lilly and Company (Lilly), we are marketing Cialis® (tadalafil) for the treatment of erectile dysfunction. Lilly ICOS also is evaluating tadalafil as a potential treatment in benign prostatic hyperplasia (BPH), hypertension and pulmonary arterial hypertension (PAH). ICOS also is working to develop and commercialize potential treatments for other serious unmet medical conditions such as cancer and inflammatory diseases.

 

Over the years, we have established collaborations with pharmaceutical and biotechnology companies to enhance our internal development capabilities, to acquire rights to additional product candidates, to gain access to the capabilities of our collaboration partners and to offset a substantial portion of the financial risk of developing individual product candidates. Our most significant ongoing collaboration is Lilly ICOS. We expect to establish additional collaborations with pharmaceutical and other biotechnology companies in the future.

 

Business Strategy

 

ICOS is focused on the discovery, development and commercialization of innovative drugs.

 

Successfully commercializing Cialis in the United States, Europe and other countries.    With the United States Food and Drug Administration’s (FDA) 2003 approval of Cialis for erectile dysfunction, and subsequent Cialis product launch in the United States, we have succeeded in bringing our first product to market on a worldwide basis. Through the sales and marketing efforts of both Lilly and ICOS, we intend to continue to increase awareness of the unique benefits of Cialis, as we expand our position in the large and growing worldwide erectile dysfunction market.

 

Diversifying and commercializing our portfolio of product candidates.    We have developed, and plan to continue to develop, a portfolio of product candidates encompassing a variety of therapeutic approaches to address both chronic and acute diseases and medical conditions. For example, we are currently researching and developing product candidates targeting, among others, cardiovascular diseases, urologic disorders, cancer and inflammatory diseases. To mitigate some of the risks inherent in clinical development, we plan to develop a number of product candidates concurrently. We believe this diversified approach yields the greatest opportunity for long-term commercial success.

 

Using our internal capabilities to discover and develop novel product candidates.    We have used our capabilities in molecular, cellular and structural biology, high throughput drug screening, medicinal chemistry and gene expression profiling to successfully identify novel product candidates. We have obtained patents, or filed patent applications, for protein-based and small molecule product candidates. We plan to continue our discovery and development efforts in these areas, emphasizing diseases and medical conditions for which current therapies are substandard or unavailable, or for which the market opportunities are large.

 

Identifying attractive acquisition and in-licensing candidates.    We have acquired and in-licensed product candidates and plan to continue to do so in the future. We believe that we are well positioned to attract additional product candidates as a result of our broad base of research, clinical and development capabilities, as well as our experience bringing a collaboratively developed product to market.

 

Forming strategic collaborations.    We have established, and intend to continue to establish, collaborations with pharmaceutical and other biotechnology companies to enhance the development of product candidates.

 

1


Table of Contents

These collaborations enable us to retain a significant portion of the potential economic benefit, while offsetting a substantial portion of the financial risk. We believe collaborations generally enable us to develop a greater number of product candidates than otherwise would be possible and also provide us with access to a broader range of scientific and commercial capabilities through our collaborative partners.

 

Expanding our intellectual property portfolio.    We intend to continue to aggressively pursue protection of our proprietary technology and other intellectual property. We believe that establishing a strong proprietary position could provide an important competitive advantage in our target markets. We have applied, and are applying, for patents for Cialis, our product candidates and unique aspects of our technologies, in the United States and in other countries.

 

Cialis

 

Our first commercial product, Cialis, is being prescribed around the world as an on-demand treatment for patients with erectile dysfunction. Cialis is being manufactured and marketed by Lilly ICOS, which has rights to commercialize Cialis in North America and Europe. In the context of Lilly ICOS territories, North America includes the United States, Canada and Mexico. Europe includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. Lilly has exclusive rights to market Cialis in all other parts of the world, and pays royalties to Lilly ICOS equal to 20% of net sales in those territories. Worldwide net sales of Cialis totaled $746.6 million during the year ended December 31, 2005, including $169.9 million in Lilly territories.

 

Cialis is an oral inhibitor of the phosphodiesterase type 5 enzyme (PDE5), shown to be effective in relaxing smooth muscle tissue. Lilly ICOS has conducted approximately 112 clinical studies, involving more than 15,000 human subjects, in evaluating Cialis for the treatment of erectile dysfunction. Efficacy studies demonstrated that Cialis both improved a patient’s ability to attain and maintain an erection sufficient for sexual intercourse and significantly increased the percentage of successful sexual attempts. Clinical studies further demonstrated that Cialis is effective up to thirty-six hours after taking the drug and may work as early as thirty minutes after dosing. We believe that the drug’s duration and the ability to take the drug without regard to food allows men and their partners more freedom and spontaneity to choose the right moment for sexual activity.

 

Background.    Erectile dysfunction is a condition in which a man is unable to attain or maintain an erection sufficient for sexual intercourse. Erectile dysfunction affects an estimated 30 million men in Europe and an estimated 40 million men in North America and is increasingly recognized as a serious and treatable medical condition. Erectile dysfunction is often associated with underlying diseases such as diabetes, cardiovascular disease and depression, or may be a neurological consequence of conditions such as prostate surgery, spinal cord injury or treatment with certain medications.

 

Typically, sexual arousal leads to increased blood flow into penile erectile tissue, resulting in an erection. As part of this arousal process, the body produces a compound called cyclic guanosine monophosphate (cGMP) which causes penile blood vessels to dilate, allowing blood flow to increase. PDE5, an enzyme present in penile blood vessels, cleaves cGMP allowing the penile blood vessels to return to their undilated state. Inhibition of PDE5 can enhance blood flow to the penis, thus, contributing to an erection.

 

Current Treatment.    Until 1998, treatments for erectile dysfunction were primarily limited to the use of injectables, vacuum pumps and prostheses, which are inconvenient and unpleasant options that had limited the size of the treated population. With the introduction, in 1998, of Viagra® (sildenafil citrate), which also inhibits PDE5, millions of men were motivated for the first time to acknowledge their affliction and seek treatment. In 2003, Levitra® (vardenafil HC1), was introduced as an alternative treatment for erectile dysfunction. We believe that less than 10% of the world’s male population who could benefit from orally administered treatment for erectile dysfunction are currently undergoing treatment.

 

2


Table of Contents

Research and Development Pipeline

 

We are studying and developing product candidates targeting a variety of serious diseases and medical conditions, as summarized in the following paragraphs.

 

Total research and development expenses were $88.3 million in 2005, $71.8 million in 2004 and $85.8 million in 2003.

 

Clinical Programs

 

Tadalafil

 

Besides erectile dysfunction, we are currently studying tadalafil in BPH, hypertension and PAH.

 

Benign Prostatic Hyperplasia (BPH)

 

Background.    BPH is a non-cancerous enlargement of the prostate gland that may cause a number of bothersome urinary tract symptoms as a man ages. The enlarging prostate gland impacts a man’s urination, by exerting pressure upon the urethra, the passageway for urine leaving the bladder. In men diagnosed with BPH, the enlarging prostate may narrow or partially block the urethra, which can result in urinary difficulties. The symptoms of BPH include having to strain to pass urine, urgency with frequent urination, repeated awakening at night to urinate, incomplete emptying of the bladder and even the inability to urinate. More than half of men over age 50 have some degree of BPH.

 

Current Treatment.    BPH is a competitive market with several approved drugs. Currently, alpha blockers (e.g., doxazosin (Cardura®), terazosin (Hytrin®), tamsulosin (Flomax®), alfuzosin (Uroxatral®)) and 5-alpha-reductase inhibitors (e.g., finasteride (Proscar®), dutasteride (Avodart®)) are used, separately or in combination, to treat the symptoms of BPH. Such treatments typically relax the smooth muscle tissue in the prostate and the opening of the bladder, reduce the size of the prostate or slow the rate of prostate enlargement, thereby allowing urine to flow more freely. Although effective, both classes of drugs can produce unwanted side effects, including sexual dysfunction, which may prompt patients to avoid or discontinue therapy and may be exacerbated with combination therapy. Additionally, certain approved therapies for BPH are associated with appreciable rates of dizziness and syncope. Other treatments of BPH include transurethral microwave heat treatment, transurethral needle ablation, stents and surgery.

 

Potential Treatment by Tadalafil.    Tadalafil inhibits PDE5, thereby increasing cGMP levels, which may cause relaxation of prostatic and lower urinary tract smooth muscle or provide symptomatic relief through other mechanisms in the lower urinary tract.

 

Development Status.    Lilly ICOS obtained positive results in a Phase 2 clinical study evaluating tadalafil for the treatment of lower urinary symptoms in men with BPH. The Phase 2 proof of concept study demonstrated significant improvement, relative to placebo, in the primary endpoint, the International Prostate Symptom Score (IPSS). The IPSS is a seven-item questionnaire that assesses the severity of symptoms of BPH and is the standard scale used for the evaluation of medications that treat the symptoms of BPH. In addition, tadalafil demonstrated significant improvement relative to placebo on most of the secondary endpoints included in the study. Lilly ICOS plans to proceed with a Phase 2b clinical study in 2006, which may serve as one of two pivotal studies, to evaluate multiple doses of tadalafil in patients with BPH. The results of the multi-dose study will be useful in the design of a Phase 3 study, expected to begin in 2008.

 

Hypertension

 

Background.    Hypertension, or high blood pressure, is a common disorder which dramatically increases the risk of cardiovascular complications. Patients with hypertension are at greater risk for heart attacks, stroke,

 

3


Table of Contents

kidney failure and atherosclerosis. It is estimated that hypertension affects more than 71 million people in the United States. Of the estimated 50 million people who have been diagnosed with hypertension, it is estimated that approximately 45 million are using therapy (special diet or medication) to control the effects of this disorder.

 

Current Treatment.    Numerous agents for the treatment of hypertension exist, including diuretics, adrenergic antagonists, calcium channel blockers and angiotensin converting enzyme inhibitors. A number of these agents can negatively affect libido and sexual performance, impeding patient compliance with therapy.

 

Potential Treatment by Tadalafil.    Tadalafil’s inhibition of PDE5, thereby increasing cGMP levels, may cause a reduction in vascular tone and, hence, blood pressure. Preclinical data and preliminary clinical observations suggest that tadalafil administration to people with hypertension may result in a clinically meaningful reduction in blood pressure.

 

Development Status.    In September 2005, Lilly ICOS initiated a Phase 2 study to evaluate the efficacy and safety of tadalafil, compared to placebo, for the treatment of mild to moderate hypertension.

 

Pulmonary Arterial Hypertension (PAH)

 

Background.    PAH is a life threatening disease that is characterized by an elevation of blood pressure in the pulmonary (lung) arteries. Patients who have PAH can experience shortness of breath, fatigue and heart failure. In the United States, PAH affects an estimated 100,000 people of all ages. Left untreated, PAH is typically fatal.

 

Current Treatment.    PAH is a competitive market with five therapies currently approved in North America and Europe, including inhaled, intravenous, and subcutaneously administered prostacyclin and analogs; an oral endothelin receptor antagonist; and an oral PDE5 inhibitor. Such agents are designed to improve circulation in part by dilating blood vessels in the affected pulmonary artery. Patients may also be treated with supplemental oxygen, digoxin, diuretics, warfarin or calcium channel blocking medications.

 

Potential Treatment by Tadalafil.    Regulatory bodies in the U.S. and Europe have approved the use of sildenafil citrate (Revatio®), the active ingredient in Viagra®, for the treatment of patients with PAH. Because of tadalafil’s longer half-life (17.5 hours), it may be preferable to other PDE5 inhibitors. This half-life may make it feasible for once-a-day dosing with tadalafil, which could be advantageous in the treatment of PAH.

 

Development Status.    In August 2005, Lilly ICOS initiated a Phase 3 study to evaluate the efficacy and safety of tadalafil, compared to placebo, for the treatment of PAH. The study is being conducted in North America and Europe.

 

Discovery and Preclinical Research

 

As part of our discovery research program, we evaluate new product candidates. We use an integrated approach in this process that incorporates our capabilities in molecular, cellular and structural biology, high throughput drug screening, medicinal chemistry and gene expression profiling. The following table summarizes our research and preclinical programs, as defined through therapeutic disease focus areas.

 

     
  Therapeutic Area    Indication    Status
  Inflammation    Psoriasis, Asthma    Preclinical
  Urology    Overactive bladder    Preclinical
  Oncology    Non-small cell lung cancer/others    Preclinical, Research
  Fibrotic diseases    Kidney disease    Research

 

4


Table of Contents

In the status column of the above table: “Preclinical” indicates evaluation of lead or preferred compounds or antibodies for safety, pharmacology and proof of efficacy in non-human animal models; and “Research” indicates the identification process for compounds or antibodies for which activity in target human biological assay systems has been demonstrated in laboratory tests, but which have not yet been tested in non-human animal models of specific human diseases.

 

Inflammation

 

ICOS continues to develop small molecule antagonists potentially useful in the treatment of inflammatory diseases. One program targets adhesion proteins that are expressed on the surface of white blood cells and function as both regulators of cell movement and of cell signaling. Psoriasis is the primary disease target for this antagonist. A second program is aimed at developing a drug that might be particularly important in allergic inflammatory diseases, such as asthma.

 

Urology

 

As a result of our work on Cialis, we have developed preclinical expertise in the study of the bladder and prostate gland, which has led to the evaluation of compounds that might relieve patients’ symptoms of an overactive bladder. There are approximately 33 million patients with an overactive bladder in the United States alone. These individuals often endure severe lifestyle restrictions, inconvenience and social embarrassment. Available therapies are only partially effective and often have unattractive side effects. We have initiated a program to develop substantially improved therapies for this condition. One project is currently in preclinical testing.

 

Oncology

 

According to the American Cancer Society, cancer is a major cause of death in the U.S., second only to cardiovascular disease. Despite significant progress in researchers’ understanding of the underlying molecular changes that drive the initiation and progression of cancers, treatment of these diseases remains largely unsatisfactory. For this reason, there is tremendous opportunity to develop novel therapeutics that may have a meaningful impact on the quality of life of patients and have significant commercial potential. For example, in recent years, several monoclonal antibodies have been developed to treat cancer. ICOS has experience in the development and clinical progression of monoclonal antibodies, and we have identified several molecules that have potential as monoclonal antibody targets in life threatening cancers, including non-small cell lung cancer.

 

One of our more advanced oncology programs involves the evaluation of cell cycle checkpoint/DNA repair inhibitors for their potential to improve the effectiveness of radiation and chemotherapy treatments. Resistance of tumor cells to radiation or chemotherapy is due in part to cell cycle checkpoint/DNA repair enzymes. These enzymes recognize and repair potentially lethal defects in cellular DNA introduced by radiation or chemotherapeutic agents. In preclinical tests, we are currently evaluating and optimizing lead compounds that inhibit key enzymes involved in this process. We are assessing these compounds, as well as those that target lipid and protein kinases, for their ability to selectively increase the sensitivity of tumors versus normal tissue to radiation or chemotherapeutic agents. This approach may enhance the success and minimize the toxic effects of chemotherapeutic treatments for many different types of tumors.

 

Fibrotic Diseases

 

Fibrosis is a leading cause of morbidity and mortality and a key component of multiple diseases affecting millions of people worldwide. Fibrosis can best be described as an improperly regulated wound healing response and is a common reaction of tissues to injury. During chronic injury, the wound healing response is no longer controlled by the normal mechanisms, thus resulting in abnormal deposits of fibrotic, or hardened, material.

 

5


Table of Contents

These deposits may eventually lead to tissue dysfunction and potential failure of the affected organ. Despite this large unmet medical need, there are currently no approved treatments that directly target the process of fibrosis.

 

There is a great deal of overlap between the cellular and chemical mediators involved in fibrosis and those controlling the immune response. In addition, the nature of myofibroblast activation and differentiation has many similarities to neoplastic transformation that occurs in cancer. Therefore, it is not surprising that drug targets exist that have overlap between cancer or inflammatory disease and fibrotic disease. We are currently leveraging our expertise in cancer and inflammatory disease research to look at applications within fibrotic disease systems with an initial focus on fibrotic kidney diseases, such as diabetic nephropathy.

 

Patents and Proprietary Rights

 

Pharmaceutical and biotechnology companies have traditionally placed considerable importance on obtaining and maintaining patent protection for significant new technologies, products and processes. We have applied, and are applying, for patents for our product candidates and aspects of our technologies both in the United States and, when appropriate, in other countries. Patents have been issued on many of these applications. We have also obtained rights to various patent applications and patents under licenses with third parties.

 

Irrespective of whether we own or in-license patents, there can be no assurance that our patents will provide us with significant protection, competitive advantage or commercial benefit. The validity and enforceability of patents issued to pharmaceutical and biotechnology companies has proven highly uncertain. For example, legal considerations surrounding the validity of patents in the fields of pharmaceuticals and biotechnology are in transition, and we cannot assure you that the legal standards of patent law applied historically will continue to be applied in the future. In addition, we cannot assure you as to the degree and range of protections that any of our patents may afford us or whether any patents will be issued. Furthermore, since publication of discoveries in scientific or patent literature necessarily lags behind actual discoveries, we cannot assure you that we were the first creator of inventions covered by our patents or pending patent applications, or that we were the first to file patent applications for these inventions.

 

Many pharmaceutical and biotechnology companies and university and research institutions may have filed patent applications or already received patents that may be relevant to our areas of product development. Many of these applications and patents may be competitive with or conflict with ours, and could prevent us from obtaining patents or could call into question the validity of our existing patents. To contend with these possibilities, we have entered into license agreements and may in the future enter into additional license agreements to obtain access to technologies that may be useful or necessary for the development or commercialization of some of our product candidates. However, we cannot assure you that these licenses, or any others that may be required, will be available on commercially reasonable terms, if at all, or that we will be able to develop alternative technologies if we cannot obtain required licenses.

 

To protect our rights to our patents and proprietary information, we may need to litigate against infringing third parties, or avail ourselves of the courts or administrative proceedings to determine the scope, validity or enforceability of our patent rights. These types of actions are often costly and could be very time-consuming to us, and we cannot assure you that the deciding authorities will rule in our favor. An unfavorable decision could allow third parties to use our technology without being required to pay us licensing fees or may compel us to license needed technologies to avoid infringing third party patent and proprietary rights. Likewise, we may be required to defend ourselves in patent suits brought by third parties who seek to enjoin our product development efforts or seek damages for infringement. An unfavorable decision could force us to, among other things, alter our operations, pay damages or licensing fees or discontinue developing or marketing one or more of our potential products, as well as incur significant legal expenses. See “Item 3, Legal Proceedings” for a description of our material patent litigation.

 

While we pursue patent protection and enforcement of our product candidates and aspects of our technologies when appropriate, we also rely on trade secrets, know-how and continuing technological

 

6


Table of Contents

advancement to develop and maintain our competitive position. To protect this competitive position, we regularly enter into confidentiality and proprietary information agreements with third parties, including employees, suppliers and collaborators. Furthermore, our know-how that is accessed by third parties through collaborations and research and development contracts and through our relationships with scientific consultants is generally protected through confidentiality agreements and material transfer agreements with the appropriate parties. We cannot, however, assure you that these protective arrangements will be honored by all third parties, including employees, suppliers and collaborators, or that these arrangements will effectively protect our rights relating to unpatented proprietary information, trade secrets and know-how. In addition, we cannot assure you that other parties will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our proprietary information and technologies.

 

Cialis

 

We have several issued U.S. patents and numerous corresponding foreign patents covering Cialis and certain uses thereof. In the United States and Europe, our principal patents and/or applications covering Cialis or its uses expire between 2015 and 2020, subject to any patent term extensions that may be available.

 

In connection with the treatment of erectile dysfunction, our principal competitor, Pfizer Inc., or Pfizer, has been granted U.S. and foreign patents. See “Item 3, Legal Proceedings” for a description of our material litigation with Pfizer regarding Cialis.

 

Government Regulation

 

Regulation by government authorities in the United States, Europe and other countries is a significant consideration in our ongoing research and product development activities and in the manufacture and marketing of Cialis. Any product candidates we develop will require regulatory approval by government agencies prior to commercialization. Human therapeutic products are subject to rigorous preclinical and clinical testing and other approval requirements by the U.S. Food and Drug Administration (FDA) and comparable agencies in foreign countries. The time required for completing testing and obtaining approvals of our product candidates is uncertain, but often takes many years. Any delay in the approval of testing or in the evaluation of preclinical or clinical results by governmental authorities may hinder product development. Various federal, state and foreign statutes and regulations, including the Federal Food, Drug and Cosmetic Act, as amended, and the regulations promulgated thereunder, also regulate the manufacturing, safety, labeling, storage, record keeping, advertising, promotion and marketing of our approved product (Cialis). Failure to comply with these legal requirements may subject us to, among other things, civil penalties, criminal prosecution and restrictions on product development, production and/or distribution.

 

In general, the steps ordinarily required before a new therapeutic product candidate may be marketed in the United States include:

 

    preclinical laboratory tests, animal tests and formulation studies;

 

    the submission to the FDA of an Investigational New Drug Application (IND), which must become effective before clinical testing may begin in humans;

 

    the conduct of a series of adequate and well-controlled clinical studies, conducted in phases to first establish the safety in humans and then the efficacy of the product candidate for each indication and related patient population;

 

    the submission of a New Drug Application (NDA) or Biologics License Application (BLA), as the case may be, to the FDA; and

 

    FDA review and approval of an NDA or BLA, as the case may be, prior to any commercial sale or shipment of the product candidate.

 

7


Table of Contents

Preclinical studies generally are conducted in the laboratory to evaluate the potential safety and efficacy of a therapeutic product candidate and are undertaken in compliance with Good Laboratory Practices regulations and FDA guidance. The results of these studies are submitted to the FDA as part of an IND, which must be reviewed by the FDA before clinical testing may begin in the United States. Once the IND becomes effective (after FDA approval or failure to comment), clinical studies on humans may begin, although the FDA may put a hold on these studies at any time. Additional studies in animals are conducted after the IND is effective, and the results are submitted to the FDA to justify continued testing of the drug in humans.

 

Clinical studies are conducted in accordance with Good Clinical Practices regulations and related standards at independent investigator sites under protocols that detail the objectives of the study, the parameters to be used in monitoring safety and the efficacy criteria to be evaluated. Typically, clinical evaluation involves three phases, which may overlap. During Phase 1, clinical studies are conducted with a relatively small number of subjects to determine the early safety profile of a drug, as well as the pattern of drug distribution and drug metabolism by the subject. In Phase 2, clinical studies are conducted with groups of patients afflicted by a specific target disease to determine preliminary efficacy, optimal dosages and dosage tolerance, and to gather additional safety data. In Phase 3, large-scale, multicenter comparative clinical studies are conducted with patients afflicted with a specific target disease to provide data for the statistical proof of efficacy and safety as required by the FDA and others. The FDA or a clinical study sponsor may suspend clinical studies at any time if it is believed that the participants are being exposed to an unacceptable health risk.

 

The results of preclinical and clinical testing of a product candidate, as well as data relating to a product candidate’s chemistry, pharmacology and manufacture, are submitted to the FDA, in the form of an NDA for small molecule products or a BLA for biological products, in order to seek FDA approval. The cost of this process may be substantial. In response to an NDA or BLA, the FDA may grant marketing approval, request additional information or deny the application if the FDA determines that the application does not satisfy its regulatory approval criteria, including the pre-approval of relevant product manufacturing facilities. No action can be taken to market any new drug or biologic product in the United States until an appropriate marketing application has been approved by the FDA. The FDA may require additional testing after approval. In addition, we must conduct surveillance programs to monitor the side effects or adverse events associated with use of a new product. The FDA may prevent or limit future marketing of a product based on the results of these post-marketing analyses. Additional testing is also required to gain approval for the use of a product as a treatment for indications other than those already approved.

 

In order to manufacture our potential products, a domestic drug manufacturing facility must be (i) registered with the FDA, (ii) must submit to periodic inspection (including a pre-approval inspection) by the FDA and (iii) must comply with current Good Manufacturing Practices, or GMP, regulations. In addition, to supply products for use in the United States, foreign manufacturing establishments must comply with these regulations and are subject to periodic inspection by the FDA or corresponding regulatory agencies in countries under reciprocal agreements with the FDA.

 

Whether or not FDA approval has been obtained, approval of a product by comparable regulatory authorities may be necessary in foreign countries prior to the commencement of marketing of a product in those countries. The approval procedures vary among countries and can involve additional testing and substantial delays. Although there are some procedures for unified filings in some countries, including some in Europe, in general each country has its own procedures and requirements.

 

With the approval of Cialis for sale in the United States, we are also subject to various federal and state laws pertaining to health care “fraud and abuse,” including anti-kickback laws and false claims laws. Anti-kickback laws make it illegal for a prescription drug manufacturer to solicit, offer, receive or pay any remuneration in exchange for, or to induce, the referral of business, including the purchase or prescription of a particular drug. The federal government has published regulations that identify exemptions or “safe harbors” for certain payment arrangements that do not violate the anti-kickback statutes. Due to the breadth of the statutory provisions and the

 

8


Table of Contents

absence of guidance in the form of regulations or court decisions addressing certain practices, it is possible that our future practices might be challenged under anti-kickback or similar laws. False claims laws prohibit anyone from knowingly and willingly presenting, or causing to be presented for payment to third party payors (including Medicare and Medicaid) claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services. Violations of fraud and abuse laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal health care programs (including Medicare and Medicaid). If the government were to allege against or convict ICOS, Lilly, or Lilly ICOS, of violating these laws, there could be a material adverse effect on us, including our stock price. Our future activities could be subject to challenge for the reasons discussed above and due to the broad scope of these laws and the increasing attention being given to them by law enforcement authorities.

 

Our activities relating to the marketing and promotional labeling of our products are also subject to regulation under the Food, Drug and Cosmetic Act, as amended, and the accompanying regulations and guidance. These requirements are designed to ensure that promotional communications about pharmaceutical products are balanced and accurate. Promotional materials are submitted to the FDA’s Division of Drug Marketing and Communications (DDMAC) no later than the time of first use, but in most cases advance approval is not required. Television advertisements are often sent to DDMAC for advisory comments before they are run, which may result in changes to the advertisement. If DDMAC determined that one or more of our promotional communications violated the applicable standards, we could be required to remove the advertisement from distribution and/or issue corrective communications. Any such actions might negatively impact our promotional strategy. In extreme cases, such as those involving patient safety concerns as a result of a company’s marketing activities, the FDA has the authority to issue a seizure order or to require the company to discontinue marketing of its product in the United States.

 

Recently, broadcast advertising for prescription drugs has been a particular focus of attention by Congress and the media. A set of principles relating to advertisements to consumers was adopted in July 2005 by the Pharmaceutical Research and Manufacturers of America, a pharmaceutical industry association. We do not currently believe that compliance with these principles will materially impair our ability to market Cialis. However, if public attention to this issue continues or intensifies, regulatory bodies or industry groups may feel pressured to impose additional limitations in this area. Future restrictions (in the form of laws, regulations or additional guidelines) on direct-to-consumer advertising of erectile dysfunction medications could impact us and our competitors; however, the relative impact on each product might be affected by other factors such as length of time on the market or current recognition of the brand.

 

Our research and development activities involve the controlled use of chemicals, viruses, radioactive compounds and other hazardous materials. If an accident involving these materials were to occur, we could be held liable for any resulting damages, which liability could exceed our resources. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous materials and certain waste products. We are also subject to various federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices and the experimental use of animals.

 

Additionally, our present and future business is and will continue to be subject to various other forms of government regulation. The extent and character of government regulation that might result from future legislation or administrative action cannot be accurately predicted and may materially affect us.

 

Competition

 

Competition in the pharmaceutical and biotechnology industries is intense and is expected to increase over time. Cialis is encountering intense competition, and we expect that our product candidates will encounter significant competition as well, should they reach the market. A number of pharmaceutical and biotechnology

 

9


Table of Contents

companies are currently developing products targeting many of the same diseases and medical conditions that we target, and some of our competitors’ products have entered clinical studies or are already commercially available.

 

Many of our competitors have substantially more experience, capital, research and development, regulatory, manufacturing, sales, marketing, human and other resources than we do. Furthermore, significant levels of biotechnology and pharmaceutical research now occur in universities, government agencies and other nonprofit research institutions. All of these entities have become increasingly active in seeking patent protection and licensing revenues for their research results, thereby providing us with additional future competition and potential costs to our operations.

 

We believe the principal competitive factors affecting our markets are the timing and scope of regulatory approvals, safety and efficacy of therapeutic products, cost and availability of these products, availability of alternative treatments, third party reimbursement programs and patent and proprietary rights protection. Although we believe that we are positioned to compete adequately with respect to these factors in the future, our future success is difficult to predict. Our product candidates are in various stages of development and, accordingly, subject to substantial research, development, regulatory approval and commercialization risks. The timing of market entry can be an important factor in determining a new product’s eventual success and profitability. Early entry may have important advantages in gaining product acceptance and market share. Therefore, the relative speed with which we can develop products and receive regulatory approval will likely be important to our competitive success.

 

The erectile dysfunction market is well established and intensely competitive. Throughout most of the world, Cialis competes against Viagra, which Pfizer has already successfully commercialized, and Levitra, which is being commercialized by Bayer AG outside the United States, and GlaxoSmithKline and Schering-Plough Corporation in the United States. Like Cialis, both Viagra and Levitra are PDE5 inhibitors for the treatment of erectile dysfunction. Our principal competitor, Pfizer, is the largest pharmaceutical company in the world and GlaxoSmithKline is the third largest. Another PDE5 inhibitor, Zydena® (udenafil), was approved for marketing in Korea in November 2005, and an investigational new drug application related to this product has been filed with the FDA. Other erectile dysfunction treatments are in development, and any other products or technologies that are directly or indirectly successful in treating erectile dysfunction could negatively impact the market for Cialis. If a PDE5 inhibitor with a time of effectiveness comparable to or longer than that of Cialis or a generic PDE5 inhibitor is successfully commercialized, it might have a significant adverse effect on the market for Cialis.

 

Tadalafil, if approved for the treatment of BPH, would compete with products such as Flomax and Cardura, which are alpha one antagonists, and Proscar and Avodart, which are dihydrotestosterone inhibitors. In addition, Pfizer recently announced favorable results of its Phase 2 study of Viagra on the treatment of BPH.

 

If approved for the treatment of PAH, tadalafil would compete with established products such as Flolan, Ventavis, Remodulin and Tracleer, as well as Pfizer’s new product Revatio, which was approved for marketing in the United States in June 2005 and in the European Union in November 2005. The active ingredient in Revatio is sildenafil, which is also the active ingredient in Viagra.

 

Our other potential products, if approved and commercialized, could compete against well-established existing therapeutic products as well.

 

Manufacturing

 

Cialis is currently manufactured by Lilly under contract with Lilly ICOS. Certain aspects of the Cialis manufacturing process are only performed in one Lilly location. Lilly also depends on others for the timely supply of raw materials used to manufacture Cialis and the performance of certain manufacturing processes. There can be no assurance that Lilly ICOS will be able to accurately anticipate future demand for Cialis or maintain adequate manufacturing capacity.

 

10


Table of Contents

We have established relationships with third party manufacturers to produce the required materials for our small molecule programs. In addition, we have a facility in Redmond, Washington, a suburb of Seattle, which gives us the ability to manufacture active pharmaceutical ingredient (API) in limited quantities to support our non-commercial needs.

 

We manufacture recombinant protein-based clinical materials in our production facility in Bothell, Washington, a suburb of Seattle, to support our clinical studies. Our current facility is capable of utilizing both microbial- and mammalian-based production processes and was designed to meet the FDA requirements for the production of purified recombinant protein bulk product. In the absence of a need to manufacture our own product candidates at our production facility, we are manufacturing purified recombinant protein bulk product for third parties pursuant to contractual arrangements and may enter into additional arrangements in the future.

 

We depend on the timely supply of raw materials used to manufacture product candidates for use in preclinical testing and clinical studies and for our contract manufacturing business. We attempt to remain apprised of our supplier’s abilities to meet our needs and the market conditions for these raw materials. Raw materials may be subject to contamination and recall. A material shortage, contamination or recall could adversely impact or disrupt the manufacturing of our product candidates. We cannot assure you that we will be able to maintain our current relationships with third party manufacturers and suppliers or establish future arrangements with third party manufacturers and suppliers on commercially reasonable terms, if at all. We participate in quality control and quality assurance processes related to the manufacture of potential products for us and our affiliates. However, there is no assurance that regulatory bodies will not raise issues regarding manufacturing and quality processes.

 

Marketing and Sales

 

Cialis

 

In 2003, we hired and deployed an ICOS sales force of approximately 165 experienced pharmaceutical sales representatives that, together with sales representatives from Lilly, co-promote Cialis throughout the United States on behalf of Lilly ICOS. ICOS sales representatives are focused primarily on physicians in private practice, specializing in the field of urology. We utilize typical pharmaceutical company selling and marketing techniques, including sales representatives calling on individual physicians, medical education programs, professional symposia, promotional materials and public relations. In January 2006, we added an additional 40 representatives through a third party to promote Cialis in the United States on behalf of Lilly ICOS.

 

Costs of marketing and selling Cialis are charged to Lilly ICOS and reported as collaboration revenue from related parties in our consolidated statements of operations. Beginning in September 2003, and continuing through December 2004, the costs of our sales force were fully reimbursed by Lilly ICOS. Beginning in January 2005, 60% of the cost of our sales force is reimbursed by Lilly ICOS. The cost of the 40 third party sales representatives managed by us and Cialis marketing activities will be fully reimbursed by Lilly ICOS.

 

We have limited marketing support service experience and, therefore, rely heavily on Lilly to supply these services for Cialis in the United States, including customer service, order entry, shipping and billing services. Lilly is currently responsible for all sales and marketing activities for Cialis outside the United States. Based on the terms of our marketing and sales agreement with Lilly ICOS and Lilly, beginning in 2007, we may be required to assume a portion of the sales and marketing responsibilities for Cialis in Canada, Mexico and Europe. As an alternative to deploying our own sales force, we may fulfill our sales and marketing responsibilities in those territories by contracting with Lilly or third parties. In the event we deploy our own sales force, we will be reimbursed in a manner similar to how we are reimbursed in the United States.

 

11


Table of Contents

AndroGel® Co-Promotion

 

In January 2005, we entered into an agreement with Solvay Pharmaceuticals, Inc., whereby our U.S. sales force provided promotional support and conducted sales calls for AndroGel® (testosterone gel) 1% CIII. Under the terms of the agreement, we were paid a fee per sales call. This agreement ended in December 2005.

 

Product Candidates

 

Our marketing professionals are also focused on our product candidates under development. As development advances, marketing resource requirements will increase.

 

The manner in which we commercialize our product candidates, if successfully developed, will depend in large part on their market potential and our financial resources. In addition to our own marketing and sales force, we may establish co-promotion, corporate partnering, licensing or other arrangements for the marketing and sale of future products in some or all geographic markets.

 

We currently employ approximately 200 individuals dedicated to sales and marketing.

 

Human Resources

 

As of December 31, 2005, we employed approximately 700 individuals, all of whom are in the United States. We consider our employee relations to be good. We have never had a work stoppage, and none of our employees are represented under a collective bargaining agreement. We believe that our future success is dependent in part on our ability to attract, integrate and retain skilled scientific, sales and marketing, and other professional and senior management personnel. Competition in our industry for these skilled workers is intense, and we cannot assure you that we will be able to attract, integrate and retain these personnel.

 

Important Factors Regarding Forward-Looking Statements

 

This report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “should” or “will” or the negative of such terms or other comparable terminology. Forward-looking statements are only predictions that provide our current expectations or forecasts of future events. In particular, forward-looking statements include:

 

    information concerning possible or assumed future results of operations, trends in financial results and business plans;

 

    statements about financial guidance;

 

    statements about our product development schedule and the potential success of our research and development efforts;

 

    statements about our expectations regarding regulatory approvals for any of our product candidates;

 

    statements about our potential or prospects for future product sales;

 

    statements about the level of our costs and operating expenses, and about the expected composition of our revenues and operating expenses;

 

    statements about our future capital requirements and the sufficiency of our cash, cash equivalents, investments and financing proceeds to meet future capital and operating requirements;

 

12


Table of Contents
    statements about the outcome of contingencies, such as legal proceedings;

 

    other statements about our plans, objectives, expectations and intentions; and

 

    other statements that are not historical fact.

 

From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public such as other filings with the Securities and Exchange Commission, press releases or in our communications and discussions with investors and analysts at meetings and on webcasts and telephone calls. Any or all of our forward-looking statements in this report and in any other public statements that we make may turn out to be wrong. Inaccurate assumptions we might make and known and unknown risks, uncertainties and other factors may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, based on the information available to us at the time the statements are made, we cannot guarantee future results, performance or achievements. You should not place undue reliance on these forward-looking statements.

 

Except as required under federal securities laws and regulations, we do not have any intention or obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and Annual Reports on Form 10-K. Also note that we provide a cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our business and industry under the caption “Risk Factors” in this report. These risk factors could cause our actual results to differ materially from expected or historical results.

 

Item 1A.   Risk Factors

 

ICOS operates in an environment that involves a number of risks and uncertainties. The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not presently known to us or that are not considered material, and therefore not mentioned herein, may impair our business operations. If any of the following risks actually occur, our business, operating results and financial position could be harmed.

 

Risks Related to Our Business

 

We have a history of losses and may be unable to sustain profitability.

 

We have incurred significant operating losses since we began operations in 1990. As of December 31, 2005, we had an accumulated deficit of $862.6 million. We cannot assure you that we will be able to achieve or increase profitability. We anticipate that operating expenses will increase in the future as we continue development of our potential products, seek to obtain necessary regulatory approvals and manufacture and market these product candidates. Directly, and through Lilly ICOS, we expect to continue to incur substantial marketing and other expenses related to commercializing Cialis in the United States, Europe, Mexico and Canada. Furthermore, Lilly ICOS may incur significant expenses in demonstrating safety and efficacy in order to provide a basis for seeking regulatory approvals to market tadalafil in new indications. Lilly ICOS and/or ICOS may be unable to generate sufficient revenues from Cialis and other products to achieve and maintain profitability. Overall changes in market demand for erectile dysfunction drugs, and Lilly ICOS’ ability to capture and retain market share, will significantly affect revenues and expected profitability from Cialis and, in turn, our results of operations and cash flows. For example, in 2005, the overall U.S. market of PDE5 inhibitor prescriptions, for the treatment of erectile dysfunction, is estimated to have declined by approximately 3.2%, compared to 2004.

 

13


Table of Contents

Our operating results are subject to fluctuations that may cause our stock price to decline.

 

Our operating results have fluctuated in the past and are likely to continue to do so in the future. Our revenue and other income are unpredictable and may fluctuate due to many factors, some of which we cannot control. For example, factors affecting our revenue and other income, as well as Lilly ICOS’ revenue, presently or in the future, could include:

 

    level of demand for our products, including changes in physician prescribing habits, and unfavorable publicity concerning our products or similar products;

 

    changes in wholesaler buying patterns;

 

    changes in reimbursement rates or policies;

 

    timing of non-recurring license fees and the achievement of milestones under license and collaborative agreements;

 

    government regulation, including regulations related to the marketing of our products;

 

    increased competition for new or existing products;

 

    timing and success of product launches;

 

    level of our contract manufacturing for third parties;

 

    fluctuations in foreign currency exchange rates;

 

    changes in our product marketing, selling and pricing strategies and programs; and

 

    inability to provide adequate supply of our products.

 

In addition, our expenses, including payments owed by us under licensing or collaborative arrangements, are unpredictable and may fluctuate from quarter to quarter. We believe that quarter to quarter comparisons of our operating results are not a good indicator of our future performance and should not be relied upon to predict our future performance. It is possible that, in the future, our operating results in a particular quarter or quarters will not meet the expectations of securities analysts or investors, causing the market price of our common stock to decline.

 

Even though Cialis has been approved for commercial sale, if we or others identify additional side effects, approval could be withdrawn or sales of Cialis could be significantly reduced.

 

If we or others identify additional or potential side effects, or if manufacturing problems occur:

 

    we may take Cialis off the market;

 

    regulatory approval may be withdrawn or other regulatory sanctions may be imposed;

 

    reformulation of the product, additional clinical studies, and/or changes in labeling of the product may be required;

 

    changes to or re-approvals of our or our partner’s manufacturing facilities may be required;

 

    our reputation in the marketplace may suffer; and

 

    lawsuits, including class action suits, may be brought against us.

 

14


Table of Contents

The identification of additional or potential side effects, and subsequent consequences, could harm or prevent sales of Cialis or could increase the costs and expenses of commercializing and marketing Cialis.

 

General post-marketing surveillance of our product is ongoing, as well as specific studies that are required as part of our marketing approvals in various jurisdictions. Either of these sources could result in the identification of new or potential side effects. For example, in May 2005, Lilly ICOS added certain vision-related adverse events to the label for Cialis, based on reports from post-marketing surveillance. Subsequently, there was substantial media attention regarding a possible connection between use of Viagra® (sildenafil citrate), another PDE5 inhibitor for the treatment of erectile dysfunction, and the development of non-arteritic anterior ischemic optic neuropathy (NAION), a condition that may lead to permanent visual impairment or blindness. In July 2005, the FDA issued a statement indicating that information regarding reports of NAION in patients using PDE5 inhibitors had been added to the labels of all products in the PDE5 inhibitor class, including Cialis. The FDA statement and the relevant label language state that a causal relationship between the development of NAION and use of these drugs has not been established. Such a causal relationship could be established in the future. Adverse media attention and concerns related to side effects may reduce sales of Cialis.

 

The success of Cialis depends, in large part, on the promotion, sales and marketing activities of our partner, Lilly. Similarly, the success of our potential products in development could depend on our ability to arrange assistance from third parties.

 

Through Lilly ICOS, we and Lilly have joint responsibility for the promotion and sale of Cialis in North America and Europe. Lilly has rights to Cialis for the other parts of the world, with royalties to be paid to Lilly ICOS. We believe that the efforts of a sizeable pharmaceutical sales force and experienced marketing staff are important to the continued success of the product. We have relied, and expect to continue to rely, heavily on Lilly for promotion, sales and marketing of Cialis, even with respect to our joint responsibilities. We have limited staff and experience in these areas, and we may or may not be capable of independently fulfilling our responsibilities. We and Lilly may also rely on contract sales organizations to perform sales activities for Cialis.

 

If Lilly fails to devote appropriate resources to promotion and sales activities, sales of Cialis could be reduced or could fail to reach their full potential. In addition, if Lilly breaches or terminates its agreement with us, or otherwise fails to conduct its activities related to Cialis in an effective or timely manner, sales of Cialis could be delayed, reduced or become substantially more costly for us to achieve. We will face similar risks with respect to new product candidates that we commercialize (i.e., without the assistance of a third party, we may be unable to establish marketing, sales and distribution capabilities necessary to successfully commercialize new products). Co-promotion or other marketing arrangements with others may be needed to commercialize our potential products. However, these arrangements could significantly limit the revenues we derive from these potential products and increase associated operating expenses. Additionally, these parties may fail to commercialize our potential products successfully.

 

We may be unable to compete successfully in the markets for pharmaceutical and biotechnological products.

 

The markets in which we compete are well established and intensely competitive. We may be unable to compete successfully against our current and future competitors. Our failure to compete successfully may result in pricing reductions, reduced gross margins, failure to achieve market acceptance for our products, and an inability to achieve or grow profitability.

 

Cialis and our potential products, if approved and commercialized, compete or will compete against well established existing therapeutic products or treatments. For example, Pfizer Inc. successfully commercialized Viagra® (sildenafil citrate), a PDE5 inhibitor that competes with our product, Cialis. GlaxoSmithKline and Bayer AG, outside the United States, and GlaxoSmithKline and Schering-Plough Corporation, in the United States, are marketing Levitra® (vardenafil HCl), a third PDE5 inhibitor. Pfizer, Bayer AG, GlaxoSmithKline and Schering-Plough have invested substantial resources in marketing their PDE5 inhibitor products, and we would anticipate

 

15


Table of Contents

that they would continue efforts to aggressively compete in this market. In addition, a number of pharmaceutical and biotechnology companies are currently developing new products targeting the same diseases and medical conditions that we target. Another PDE5 inhibitor, Zydena, was approved for marketing in Korea in November 2005, and an investigational new drug application related to this product has been filed with the FDA. Other erectile dysfunction treatments are in development, and any other products or technologies that are directly or indirectly successful in treating erectile dysfunction could negatively impact the market for Cialis. If a PDE5 inhibitor with a time of effectiveness comparable to or longer than that of Cialis or a generic PDE5 inhibitor is successfully commercialized, it might have a significant adverse effect on the market for Cialis.

 

Our competitors include pharmaceutical companies, biotechnology companies, academic and research institutions and government agencies. Many of these organizations, including those who market PDE5 inhibitors that compete with Cialis, have substantially more experience and more capital, research and development, regulatory, manufacturing, sales, marketing, human and other resources than we do. As a result, our competitors may:

 

    develop products that are safer, more effective or less costly than any of our current or future products or that render our products obsolete;

 

    obtain FDA and other regulatory approvals or reach the market with their products more rapidly than we can or with labeling claims more favorable than ours, which would reduce the potential sales of our product candidates;

 

    obtain intellectual property rights that could increase our costs or prevent development or commercialization of our product candidates;

 

    devote greater resources to market or sell their products;

 

    adapt more quickly to new technologies and scientific advances;

 

    initiate or withstand substantial price competition more successfully than we can;

 

    have greater success in recruiting skilled workers from the limited pool of available talent;

 

    more effectively negotiate third-party licensing and collaborative arrangements; and

 

    take advantage of acquisition or other opportunities more readily than we can.

 

We face, and will continue to face, intense competition from other companies for collaborative arrangements with pharmaceutical and biotechnology companies, for relationships with academic and research institutions, and for licenses to products and proprietary technology. In addition, we anticipate that we will face increased competition in the future as new companies enter our markets and as scientific developments surrounding protein-based and small molecule therapeutics continue to accelerate.

 

The successful development of new therapeutic products is complex and takes a long time, and our efforts may not result in commercial products.

 

Successful development of pharmaceutical and biotechnology products is highly uncertain, and very few research and development projects produce a commercial product. Any failure or substantial delay in completing clinical trials for our product candidates may severely harm our business. We must subject our potential product candidates to extensive preclinical and clinical testing to demonstrate their safety and efficacy for humans before obtaining regulatory approval for the sale of any of such products. Clinical studies are expensive, time-consuming and may take years to complete. We may not complete preclinical tests and clinical studies of product

 

16


Table of Contents

candidates under development, and the results of the tests and studies may fail to demonstrate the safety or efficacy of such product candidates to the extent necessary to obtain regulatory approvals or to make commercialization of the product candidates worthwhile. At any time during these clinical studies, factors such as ineffectiveness of the product candidate, discovery of unacceptable toxicities or side effects, development of disease resistance or other physiological factors, or delays in patient enrollment, could cause us to interrupt, limit, delay or abort the development of these product candidates.

 

In addition, success in preclinical and early clinical studies does not ensure that late-stage or large-scale studies will succeed. Many companies in the pharmaceutical and biotechnology industries, including us, have suffered significant setbacks in clinical studies, even after promising results had been obtained in earlier studies. We have stopped two late-stage, Phase 3 clinical studies of product candidates following interim analyses: a Phase 3 study of Pafase® (rPAF-AH) for the treatment of severe sepsis was stopped in 2002; and a study of LeukArrest (rovelizumab) for the treatment of ischemic stroke was stopped in 2000.

 

We anticipate that only some of our product candidates will show safety and efficacy in clinical studies and many may encounter difficulties or delays during clinical development. Our efforts to obtain approval for additional indications for tadalafil are subject to many of the same risks associated with new products.

 

Government regulatory authorities may not approve our product candidates or may delay their approval.

 

Any failure to receive the regulatory approvals necessary to commercialize our product candidates could severely harm our business. Human therapeutic products are subject to extensive and rigorous government regulation. For example, the FDA regulates, among other things, the development, testing, manufacture, safety, efficacy, record keeping, labeling, storage, approval, advertising, promotion, sale and distribution of pharmaceutical products. Products marketed abroad are also subject to extensive regulation by foreign governments. Except for Cialis, we have not had any product candidate approved for sale in any country. In addition, we have only limited experience in filing and pursuing applications necessary to gain regulatory approvals, which may impede our ability to obtain such approvals.

 

The regulatory review and approval process is lengthy, expensive and uncertain. To secure FDA approval, we must submit extensive manufacturing, preclinical and clinical data and supporting information to the FDA, for each indication for which we are seeking approval, to establish the product candidate’s safety and efficacy. The approval process may take years to complete and may involve ongoing requirements for post-marketing studies. Any FDA or other regulatory approval of our product candidates, once obtained, may be withdrawn. The effect of government regulation may be to:

 

    delay marketing potential products for a considerable period of time;

 

    limit the indicated uses for which potential products may be marketed;

 

    specify contraindications or other risk management requirements that may limit the use of our products;

 

    impose costly requirements on us as a condition of approval or continued use of our products; and

 

    provide competitive advantage to other pharmaceutical and biotechnology companies.

 

In addition, regulatory compliance may prevent us from introducing new or improved products or may require us to stop marketing products. If we fail to comply with the laws and regulations pertaining to our business, we may be subject to sanctions, including the temporary or permanent suspension of operations, product recalls, marketing restrictions and civil and criminal penalties.

 

17


Table of Contents

We may be unable to establish or maintain the manufacturing capabilities necessary to develop and commercialize our potential products.

 

We do not currently have facilities to manufacture Cialis or our product candidates in quantities necessary for commercial sale. In addition, our manufacturing capacity may be inadequate to complete all clinical studies contemplated by us over time. We intend to rely significantly on contract manufacturers, including collaboration partners, to produce large quantities of drug material needed for clinical studies and commercialization of Cialis and our potential products. Cialis is currently manufactured by Lilly. We will have to depend on contract manufacturers to deliver materials on a timely basis and to comply with regulatory requirements, including Good Manufacturing Practices, or GMP, regulations enforced by the FDA through its facilities inspection program. Contract manufacturers may be unable to meet our needs with respect to timing, quantity or quality of materials, and may fail to satisfy applicable regulatory requirements with respect to the manufacture of these materials. If we are unable to contract for a sufficient supply of needed materials on acceptable terms, or if we should encounter delays or difficulties in our relationships with manufacturers, our revenues and potential profitability may be lower.

 

Our business may be harmed if we cannot obtain sufficient quantities of raw materials and process them reliably and timely.

 

We depend on others for the timely supply of raw materials used to manufacture Cialis and to conduct preclinical testing and clinical studies of product candidates. Once a supplier’s materials have been selected for use in our manufacturing process, the supplier in effect becomes a sole or limited source of that raw material due to regulatory compliance procedures. Presently, Lilly is the sole authorized provider of the active pharmaceutical ingredient (API) utilized in the manufacture of Cialis, and all API production for Cialis is conducted at a single Lilly facility. Lilly relies on a third-party vendor which has the exclusive rights to mill the API to conform the drug substance to specifications used in the manufacturing process. Once milled, the refined API is shipped to various Lilly locations, where the drug substance is manufactured into tablets, packaged and made ready for sale. At each of these stages in the manufacturing process, Lilly ICOS depends on an exclusive provider (i.e., Lilly or another vendor) for the timely supply and processing of raw materials. If any of these suppliers or processing facilities were to cease production or otherwise fail to supply Lilly ICOS with raw materials or manufacturing services in a timely manner, Lilly ICOS and ICOS could be materially adversely affected. Similar risks exist with respect to raw materials used in testing and developing our other product candidates.

 

If we are unable to adequately protect our intellectual property rights, the value of Cialis or of our potential products could be diminished.

 

Our success depends to a significant extent on our ability and the ability of our collaboration partners to obtain, maintain and enforce patents and other proprietary rights. Patent law relating to the scope of claims in the pharmaceutical and biotechnology fields in which we operate is still evolving and subject to a substantial degree of uncertainty. Accordingly, there may be third-party patents or patent applications relevant to Cialis or our potential products that might block or compete with the technologies and products covered by our patents or patent applications. We also cannot be certain that our pending patent applications will result in issued patents or that others have not filed patent applications for technology covered by our pending applications or that we were the first to invent the technology. A third party has filed a claim seeking to add three individuals as co-inventors on two ICOS patents. This lawsuit is described in Part I, Item 3, Legal Proceedings.

 

Additionally, although we own or control a number of patents, the issuance of a patent is not conclusive as to its validity or enforceability. Third parties may challenge the validity or enforceability of our patents. We cannot assure you regarding how much protection, if any, will be given to our patents if we attempt to enforce them and they are challenged in court or in other proceedings. It is possible that a competitor may successfully challenge our patents or that challenges will result in revocation or invalidation of the patents or in limitations of their coverage. Furthermore, the cost of litigation and administrative proceedings to uphold the validity and enforceability of patents can be substantial. If we are unsuccessful in such proceedings, third parties may be able to use our patented technologies without paying licensing fees or royalties to us.

 

18


Table of Contents

Moreover, competitors may infringe our patents or successfully avoid them through design innovation. To prevent infringement or unauthorized use, we may need to file claims based on our patents, which are expensive and time-consuming. In such proceedings, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the ground that its technology is not covered by our patents. Policing unauthorized use of our intellectual property is difficult. We may not be able to detect and prevent misappropriation of our proprietary rights related to Cialis and our other technologies, particularly in countries where the laws may not protect such rights as fully as in the United States.

 

We also rely on unpatented technology, trade secrets and confidential information. We may be unable to effectively protect our rights to this technology or information. Other parties may independently develop substantially equivalent information and techniques or otherwise gain access to or disclose our technology. It is our policy to require each of our employees, consultants and corporate partners to execute a confidentiality and intellectual property agreement at the start of their relationship with us. These agreements may not, however, provide effective protection of our technology or information and, in the event of unauthorized use or disclosure, may not provide adequate remedies.

 

We may be subject to liability and substantial damages and costs or be prohibited from marketing Cialis or commercializing our potential products as a result of patent infringement litigation and other proceedings relating to patent rights.

 

Patent litigation is common in the pharmaceutical industry. Third parties may assert patent or other intellectual property infringement claims against us or our collaboration partners regarding Cialis or our potential products. For example, we are subject to a patent lawsuit filed by Pfizer in October 2002, which alleges that the use, offering for sale, selling, manufacture or importing of Cialis, into the United States, for the treatment of erectile dysfunction by any of the defendants infringes one claim of a U.S. patent held by Pfizer. This lawsuit is described in Part I, Item 3, Legal Proceedings.

 

Ultimately we may be unable to market Cialis or commercialize some of our potential products or may have to cease some of our business operations as a result of patent infringement claims, which could severely harm our business. Even if we were to prevail, this litigation is costly and time-consuming and could divert the attention of our management and key personnel from our business operations.

 

Furthermore, after seeking advice of counsel, we may undertake research and development regarding potential products, even when we are aware of third-party patents that may be relevant to these potential products, on the basis that such third-party patents may be challenged or licensed by us. We may be subject to patent infringement claims if our subsequent challenges to such patents were not to prevail. Additionally, if our subsequent attempts to license such patents were to prove unsuccessful, we may be unable to commercialize these potential products after having incurred significant expenditures.

 

We may be required to defend lawsuits or pay damages in connection with the alleged or actual harm caused by Cialis or our product candidates.

 

We face inherent exposure to product liability claims in the event that the use of Cialis or our product candidate is alleged to have resulted in harm to others. This risk exists with respect to usage in clinical studies as well as for products that we sell. We may incur significant liability if product liability or malpractice lawsuits against us are successful. Furthermore, product liability claims, regardless of their merits, could be costly and time-consuming and could divert the attention of management and key personnel from other business concerns, or adversely affect our reputation and the demand for our products. Although we maintain product liability insurance, we cannot be certain that this coverage is adequate or that it will continue to be available to us on acceptable terms.

 

19


Table of Contents

We may be subject to product liability or other claims related to the products we manufacture for third parties.

 

We manufacture recombinant protein bulk product under contract for third parties who, in many cases, intend to use them in human clinical trials and distribute them to the public. Even though we do not distribute, market or sell the products to end users ourselves, we may be required to defend lawsuits or pay damages if any of the products is alleged to have harmed someone. We take steps to protect ourselves against the potential liabilities associated with these risks, including obtaining agreements from our customers to limit our liabilities and to indemnify us. However, we cannot be certain that these agreements will be adequate to protect us against potential claims relating to our contract manufacturing services. The scope of these agreements may vary from contract to contract. If we faced a claim that was not resolved by the applicable agreement, or if the customer failed to perform under its obligations, we may be inadequately protected or we may not be protected at all. Although we maintain product liability insurance, we cannot be certain that the coverage will apply, that it will be adequate for these claims, or that it will continue to be available to us on acceptable terms.

 

We may also be subject to claims, by our customers or others, that we committed errors during the manufacturing process. Biologics manufacturing is highly complex and new processes, in particular, can be difficult to develop and predict. Certain events could result in a contaminated product or one that did not actually perform as it was expected to perform. Although such an event may be out of our control, the customer might attempt to hold us liable for any resulting damages. We currently maintain errors and omissions insurance, but we cannot be certain that this coverage is adequate or that it will continue to be available to us on acceptable terms.

 

If we are unable to obtain additional funding needed to develop, market and sell our potential products, we could be required to delay, scale back or eliminate expenditures for some of our programs or grant rights to third parties to develop and market our potential products.

 

Our business has not historically generated the cash needed to finance our operations. We will require substantial financial resources to continue to market and sell Cialis and to conduct the time-consuming and costly research, preclinical development, clinical studies, manufacturing, regulatory, and sales and marketing activities necessary to commercialize our potential products. We may need to seek additional financing through public or private sources, including equity or debt financings, and through other alternatives, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements. Financing may, however, be unavailable when we need it or may be unavailable on acceptable terms. If we raise additional funds by issuing common stock or convertible debt securities, the percentage ownership of our existing stockholders could be reduced. Any debt or equity securities that we issue may have rights superior to those of our common stock. We may also issue debt that has rights superior to those of the holders of our convertible subordinated debt. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures for some of our marketing and selling activities and our research and development programs and grant rights to third parties to develop and market product candidates that we would prefer to develop and market on our own. If we are required to grant such rights, the ultimate value of these product candidates to us may be reduced.

 

We have a significant amount of debt that may adversely affect our financial condition.

 

We have outstanding $278.7 million aggregate principal amount of convertible subordinated notes, bearing interest at 2%. The notes mature on July 1, 2023, although holders of the notes may require us to repurchase all or part of their notes, for cash, on certain specified dates, the first of which occurs in July 2010. This is a significant amount of debt that carries a substantial debt service obligation. Our ability to meet our debt service obligations will depend on our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control.

 

20


Table of Contents

Even if we are able to meet our debt service obligations, the amount of debt we have could materially and adversely affect us in a number of ways, including by:

 

    limiting our ability to obtain financing for working capital, acquisitions or other purposes;

 

    limiting our flexibility in planning for, or reacting to, changes in our business; and

 

    making us more vulnerable to industry downturns and competitive pressures.

 

If we fail to negotiate or maintain successful collaborative arrangements with third parties, our research, development and marketing activities may be delayed or reduced.

 

We have entered into, and we expect to continue to enter into, collaborative arrangements with third parties who provide us with new products or product candidates, intellectual property, and/or funding. In addition, some third parties may perform research, development, regulatory compliance, manufacturing, or marketing activities relating to Cialis and some or all of our product candidates. The environment for collaborations relating to promising product candidates is extremely competitive. We may be unable to negotiate additional collaborative arrangements or, if necessary, modify our existing arrangements on acceptable terms. If we fail to secure or maintain successful collaborative arrangements, our research, development and marketing activities may be delayed or reduced.

 

Our collaborative agreements, including with Lilly, can be terminated by our partners under certain conditions. Even if our partners continue their contributions to the collaborative arrangements, they may nevertheless determine not to actively pursue the development or commercialization of any resulting products. Disputes may arise between us and our partners as to a variety of matters, including obligations under our agreements and ownership of intellectual property rights. Also, our partners may fail to perform their obligations under the collaborative arrangements or may be slow in performing their obligations. In addition, our partners may experience financial difficulties at any time that could prevent them from having available funds to contribute to these collaborations. In these circumstances, our ability to develop and market potential products or Cialis could be severely limited.

 

Acquisitions, mergers or investments in businesses, products or technologies could harm our business, operating results and stock price.

 

We may acquire, merge with or invest in other businesses, products or technologies that are intended to complement our existing business. From time to time in the ordinary course of business, we have had discussions and negotiations with companies regarding business combinations or investing in these companies’ businesses, products or technologies. Our management has limited or no prior experience in assimilating acquired or merged companies. Any acquisitions or investments we complete will likely involve some or all of the following risks:

 

    failure of new product candidates during the research and development stages;

 

    difficulty of assimilating the new operations and personnel, products or technologies;

 

    commercial failure of the new products;

 

    disruption of our ongoing business;

 

    diversion of resources;

 

    inability of management to maintain uniform standards, controls, procedures and policies;

 

    difficulty of managing our growth and information systems;

 

21


Table of Contents
    reduction in the overall growth rate of the combined organization;

 

    risks of entering markets in which we have little or no prior experience; and

 

    impairment of relationships with employees or customers.

 

In addition, future acquisitions, mergers or investments could result in potentially dilutive issuances of equity securities, use of cash or incurrence of debt and assumption of direct and contingent liabilities, any of which could have an adverse effect on our business and operating results or the price of our common stock.

 

The failure to attract or retain key management and technical employees and consultants could harm our business.

 

We are highly dependent on the efforts and abilities of our current management and key technical personnel. Our success will depend in part on retaining the services of our existing management and key personnel and attracting and retaining new highly qualified personnel. Failure to retain our existing key management and technical personnel or to attract additional highly qualified personnel could, among other things:

 

    delay our ongoing discovery research efforts;

 

    delay preclinical or clinical testing of our product candidates;

 

    delay the regulatory approval process;

 

    compromise our ability to negotiate additional collaborative arrangements; or

 

    prevent us from successfully commercializing our product candidates.

 

In our field, competition for qualified management and technical personnel is intense. In addition, many of the companies with which we compete for experienced personnel have greater financial and other resources than we do. As a result of these factors, we may be unsuccessful in recruiting and retaining sufficient qualified personnel.

 

Risks Related to Our Industry

 

Rapid changes in technology and industry standards could render Cialis or our potential products unmarketable.

 

We are engaged in a field characterized by extensive research efforts and rapid technological development. New drug discoveries and developments in our field and other drug discovery technologies are accelerating. Our competitors may develop technologies and products that are more effective than any we develop or that render our technology, Cialis or our potential products obsolete or noncompetitive. In addition, Cialis or our potential products could become unmarketable if new industry standards emerge. To be successful, we will need to enhance our product candidates and design, develop and market new product candidates that keep pace with new technological and industry developments.

 

Our corporate compliance program can never guarantee that we are in compliance with all laws and regulations.

 

Our operations are subject to extensive government regulation. Although we have developed and implemented a corporate compliance program, we cannot assure you that we or our employees, directors or agents are or will be in compliance with all laws and regulations. The interpretation of these requirements has

 

22


Table of Contents

evolved over time and has been unpredictable. In addition, several states are considering or have recently adopted new laws addressing various aspects of our business and pharmaceutical compliance in general. If we fail to comply with any of these laws or regulations, various negative consequences could result, including the termination of clinical studies, the failure to gain regulatory approval of a product candidate, restrictions on our products or manufacturing processes, withdrawal of Cialis from the market, significant fines or other penalties and costly litigation.

 

We may be required to defend lawsuits or pay damages in connection with the alleged or actual violation of fraud and abuse laws.

 

We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws and false claims laws. Anti-kickback laws make it illegal for a prescription drug manufacturer to offer or pay any remuneration in exchange for, or to induce, the referral of business, including the purchase or prescription of a particular drug. The federal government has published regulations that identify safe harbors or exemptions for types of payment arrangements that do not violate the anti-kickback statutes. We seek to comply with the safe harbors where possible. False claims laws prohibit anyone from knowingly and willingly presenting, or causing to be presented for payment to third-party payors (including Medicare and Medicaid), claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services. Violations of fraud and abuse laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal healthcare programs (including Medicare and Medicaid). If the government were to allege against or convict us of violating these laws, there could be a material adverse effect on our business, including our stock price. Our activities relating to the sale and marketing of our products could be subject to challenge, due to the broad scope of these laws, the absence of guidance in the form of regulations and court decisions addressing certain practices, and the increasing prosecutorial resources and attention being devoted to the sales practices of pharmaceutical companies by law enforcement authorities. During the last few years, several companies have paid multi-million dollar fines for alleged violation of fraud and abuse laws, and several other companies are under active investigation.

 

If we do not comply with laws regulating the protection of the environment and health and human safety, we could incur substantial liability.

 

Our research and development activities involve the controlled use of chemicals, viruses, radioactive compounds and other hazardous materials. If an accident involving these materials were to occur, we could be held liable for any resulting damages, which liability could exceed our resources. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous materials and certain waste products. We cannot eliminate the risk of accidental contamination or injury from these materials. We are also subject to numerous health and workplace safety laws and regulations, including those governing laboratory procedures. We may incur substantial costs to comply with, and substantial fines and penalties if we violate, any of these laws or regulations.

 

New limitations may be imposed on our ability to market Cialis or other products.

 

Broadcast advertising for prescription drugs has recently been the focus of attention by Congress and the media. Some general objections have been raised to marketing prescription drugs directly to consumers that impact the industry as a whole. In addition, some members of Congress, and others, have focused their attention on advertising for erectile dysfunction medications like Cialis, and have proposed placing limits on the hours when television advertisements for these products may be aired. We do not know at this time whether these or other limitations on the manner in which we advertise Cialis will be implemented. Even if legislation is not adopted, regulatory bodies or industry groups may feel pressured to impose limitations on marketing that affect the industry as a whole and/or erectile dysfunction medications in particular. A set of principles relating to advertisements to consumers was adopted in July 2005 by the Pharmaceutical Research and Manufacturers of

 

23


Table of Contents

America, a pharmaceutical industry association. The principles do not impose restrictions specifically on the advertising of erectile dysfunction medications, and we do not believe compliance with these principles will materially impair our ability to market Cialis. Future restrictions on direct-to-consumer advertising of erectile dysfunction medications could impact us and our competitors; however, the relative impact on each product might be affected by other factors such as length of time on the market or current recognition of the brand. Any such restrictions might impede our ability to implement our preferred promotional strategy or strategies, which may in turn affect sales of Cialis or other potential products that we market.

 

Our sales may be affected by coverage and reimbursement decisions of third-party payors.

 

Sales of Cialis and any new products we develop and commercialize may be affected by the availability of reimbursement from third-party payors, such as state and federal governments, under programs such as Medicare and Medicaid in the United States, private insurance plans and managed care organizations.

 

Because of the size of the patient population covered by managed care organizations, marketing of pharmaceuticals to them and the pharmacy benefit managers (PBMs) that serve many of these organizations is an important aspect of our business. Third-party payors and PBMs reevaluate their drug benefit plans and drug formularies from time to time, and continued access is not assured. If reimbursement levels for Cialis change adversely or if we fail to obtain reimbursement for our potential products, health care providers may limit how much or under what circumstances they will prescribe or administer them. This could result in lower product sales.

 

In October 2005, Congress passed a law that prohibits reimbursement for prescription drugs treating erectile dysfunction under the Medicare and Medicaid programs. Since coverage of erectile dysfunction drugs is not currently available under Medicare, and since several major states had previously suspended coverage for erectile dysfunction drugs under their Medicaid programs, we believe that the impact of this law on our business is not material. Nonetheless, the law eliminates the potential for some patients who could not otherwise afford these medications to receive coverage for them under these federal government programs.

 

Available Information

 

We were incorporated in the state of Delaware in September 1989. We reincorporated in Washington State in September 2005. The internet address of our corporate website is www.icos.com. We make our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports available free of charge through our internet website. In addition, we will voluntarily provide paper copies of such filings, free of charge, upon request. The ICOS Corporation Code of Conduct, which is our written Code of Ethics under Section 406 of the Sarbanes-Oxley Act of 2002, is also available on our corporate website.

 

Item 2.   Properties

 

We lease or own approximately 325,000 square feet of space in eight buildings located in Washington State. Our principal administrative offices, research laboratories and clinical production facility occupy space in these facilities. Our leases expire between October 2007 and May 2012, with options in some cases to renew for additional five- or ten-year periods. Over the next several years, we plan to lease, acquire or build additional facilities to accommodate the activities and personnel necessary to continue the anticipated growth of our business. We own approximately 300,000 square feet of undeveloped land adjacent to our corporate headquarters. We believe this property gives us additional flexibility to expand in our current geographic location if our space needs increase in the foreseeable future.

 

Item 3.   Legal Proceedings

 

In October 2002, Pfizer Inc., Pfizer Limited, and Pfizer Ireland Pharmaceuticals filed a patent infringement lawsuit against ICOS, Lilly ICOS and Lilly in the United States District Court for the District of Delaware. Pfizer

 

24


Table of Contents

contends that the use, offering for sale, selling, manufacture or importing of Cialis, into the United States, for the treatment of erectile dysfunction by any of the defendants infringes claim 24 of Pfizer’s U.S. Patent No. 6,469,012 (or the Pfizer Patent), and seeks a declaratory judgment to that effect. Pfizer also seeks a permanent injunction, attorneys’ fees, costs and expenses. In January 2003, we and the other defendants filed an answer denying the central allegations of plaintiffs’ complaint and setting forth various affirmative defenses.

 

The U.S. Patent and Trademark Office (PTO) subsequently ordered the reexamination of the Pfizer Patent. Under the reexamination process, the PTO is required to reconsider the validity of the patent if substantial new questions of patentability are raised by any party including the PTO itself. The District Court stayed, or suspended, the patent infringement lawsuit, pending the outcome of the reexamination. Subsequently, Lilly ICOS and other parties filed several reexamination requests regarding the Pfizer Patent, which were merged with the PTO’s ordered reexamination. The first office action issued by the PTO rejected claim 24 of the Pfizer Patent. The Examiner rejected claim 24 on the basis that certain prior art rendered the claimed invention not new and therefore unpatentable under 35 U.S.C. §102(b), and obvious under the judicially created doctrine of obviousness-type double patenting. The Examiner did not accept any of the other arguments made in the then-pending petitions for reexamination. We later filed a new request for reexamination of claim 24, which was granted by the PTO. Lilly also filed a separate new request for reexamination of claim 24; however, this request was denied. On September 15, 2005, the PTO issued a second office action that rejected Pfizer’s arguments made in response to the first office action, reaffirmed the initial rejection of claim 24, and entered new grounds for rejecting claim 24. The September 15, 2005 office action also maintained the obviousness-type double patenting rejection of the other claims. On November 15, 2005, Pfizer filed its response to the September 15, 2005 office action. According to PTO procedure, the PTO should issue a further action, which may finalize the rejections of claim 24, withdraw the rejections of that claim, or allow an amended claim to be entered. Pfizer can challenge the result of a final office action within the PTO and subsequently in court.

 

Litigation is inherently unpredictable and the eventual outcome in a particular case is impossible to determine in advance. We believe that Pfizer’s suit lacks merit and intend to vigorously pursue our various defenses. If Pfizer were to prevail in its suit against us, however, we might be subject to substantial damages, prohibited from marketing Cialis for the treatment of erectile dysfunction in the United States, or required by Pfizer to enter into a licensing agreement to market Cialis in the United States. Any such adverse result could have a material adverse effect on our business, financial position, results of operations and cash flows.

 

On July 20, 2005, a lawsuit was filed against ICOS by Vanderbilt University in the United States District Court for the District of Delaware. Vanderbilt filed the lawsuit asserting that three of its researchers contributed to the conception of the inventions reflected in U.S. Patent Nos. 5,859,006 and 6,140,329. U.S. Patent No. 5,859,006 is ICOS’ patent claiming tadalafil and certain related compounds; U.S. Patent No. 6,140,329 is ICOS’ patent claiming the use of tadalafil and certain related compounds to treat erectile dysfunction. Tadalafil is the active ingredient in Cialis, which is marketed in North America by Lilly ICOS, which has an exclusive license to U.S. Patent Nos. 5,859,006 and 6,140,329. The Vanderbilt lawsuit requests that the Court direct the U.S. Commissioner of Patents and Trademarks to add the three individual researchers as co-inventors on these patents. ICOS timely filed a response to the complaint on September 9, 2005, denying the central allegations of Vanderbilt’s complaint and setting forth various affirmative defenses. While the Company is diligently evaluating Vanderbilt’s claims and seeking additional information, it currently believes that Vanderbilt’s claims lack merit and intends to defend the lawsuit vigorously. Because the suit is in its early stages, it is premature to assess what, if any, impact the lawsuit might have on our business, financial position, results of operations and cash flows.

 

Item 4.   Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of ICOS’ stockholders during the fourth quarter of 2005.

 

25


Table of Contents

PART II

 

Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Information

 

Our common stock trades on The Nasdaq National Market under the symbol ICOS. The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock as reported on The Nasdaq National Market.

 

     High

   Low

2005

             

First Quarter

   $ 29.28    $ 21.44

Second Quarter

     24.97      20.02

Third Quarter

     28.83      20.88

Fourth Quarter

     30.66      24.89

2004

             

First Quarter

   $ 45.00    $ 36.76

Second Quarter

     39.76      25.85

Third Quarter

     30.15      20.96

Fourth Quarter

     29.68      20.79

 

Holders

 

As of January 31, 2006, there were 1,776 holders of record of our common stock. Because many of the outstanding shares of our common stock are held by brokers and other institutions on behalf of the beneficial stockholders, we are unable to estimate the total number of beneficial stockholders represented by the record holders.

 

Dividends

 

We have never declared or paid any dividends on our common stock. For the foreseeable future, we intend to retain earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends.

 

26


Table of Contents
Item 6.   Selected Consolidated Financial Data

 

The following selected consolidated financial data should be read in conjunction with Item 7, Management’s Discussion and Analysis of Results of Operations and Financial Condition, and the consolidated financial statements and related notes included in this Form 10-K for the year ended December 31, 2005.

 

     Year Ended December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (In thousands, except per share data)  

Statement of Operations Data:

                                        

Revenue:

                                        

Collaboration revenue from related parties

   $ 50,055     $ 56,031     $ 25,943     $ 77,728     $ 54,754  

Contract manufacturing

     16,045       16,377       12,185       8,532       7,402  

Co-promotion services

     5,310                          

Licenses of technology

           2,200       36,976       6,617       30,846  
    


 


 


 


 


Total revenue

     71,410       74,608       75,104       92,877       93,002  
    


 


 


 


 


Equity in income (losses) of affiliates

     19,519       (130,396 )     (87,180 )     (104,160 )     (64,902 )
    


 


 


 


 


Operating expenses:

                                        

Research and development

     88,289       71,791       85,758       129,350       99,009  

Marketing and selling

     42,579       39,392       19,770       9,268       2,741  

Cost of contract manufacturing

     14,028       12,561       9,703       7,599       5,198  

General and administrative

     20,275       18,247       15,272       16,409       13,795  
    


 


 


 


 


Total operating expenses

     165,171       141,991       130,503       162,626       120,743  
    


 


 


 


 


Operating loss

     (74,242 )     (197,779 )     (142,579 )     (173,909 )     (92,643 )
    


 


 


 


 


Other income (expense):

                                        

Gain on sale of partnership interests

                 10,000              

Interest expense

     (6,817 )     (6,824 )     (3,578 )            

Interest and other income

     6,217       6,355       10,038       12,292       12,470  
    


 


 


 


 


Total other income (expense)

     (600 )     (469 )     16,460       12,292       12,470  
    


 


 


 


 


Loss before income taxes

     (74,842 )     (198,248 )     (126,119 )     (161,617 )     (80,173 )

Income tax recovery

                 612              
    


 


 


 


 


Net loss

   $ (74,842 )   $ (198,248 )   $ (125,507 )   $ (161,617 )   $ (80,173 )
    


 


 


 


 


Net loss per common share — basic and diluted

   $ (1.17 )   $ (3.13 )   $ (2.01 )   $ (2.64 )   $ (1.48 )
    


 


 


 


 


Weighted-average common shares outstanding — basic and diluted

     63,996       63,435       62,561       61,304       54,073  
    


 


 


 


 


     December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (In thousands)  

Balance Sheet Data:

                                        

Cash, cash equivalents, investment securities and interest receivable

   $ 162,782     $ 275,769     $ 469,525     $ 354,025     $ 470,707  

Working capital

     122,137       206,301       397,981       162,538       381,365  

Total assets

     241,767       324,981       524,854       385,660       507,587  

Convertible subordinated debt

     278,650       278,650       278,650              

Accumulated deficit

     (862,563 )     (787,721 )     (589,473 )     (463,966 )     (302,349 )

Stockholders’ equity (deficit)

     (59,270 )     6,528       198,929       317,632       453,750  

 

27


Table of Contents

The following tables summarize our collaboration revenue from related parties, licenses of technology and equity in income (losses) of affiliates.

 

     Year Ended December 31,

 
     2005

   2004

    2003

    2002

    2001

 
     (In thousands)  

Collaboration revenue from related parties:

                                       

Lilly ICOS

                                       

Marketing and sales

   $ 26,874    $ 39,658     $ 14,921     $     $  

Research and development

     23,181      16,373       7,172       6,615       9,965  
    

  


 


 


 


       50,055      56,031       22,093       6,615       9,965  

Suncos Corporation (Suncos)

                2,450       56,478       30,373  

ICOS-Texas Biotechnology L.P. (ICOS-TBC)

                1,400       14,635       12,676  

ICOS Clinical Partners, L.P.

                            1,740  
    

  


 


 


 


     $ 50,055    $ 56,031     $ 25,943     $ 77,728     $ 54,754  
    

  


 


 


 


Licenses of technology:

                                       

Lilly ICOS

   $    $     $ 15,031     $ 1,557     $ 29,416  

ICOS Clinical Partners (affiliate)

                      3,160       981  

Biogen (non-affiliate)

                21,945       1,900       449  

Other (non-affiliates)

          2,200                    
    

  


 


 


 


     $    $ 2,200     $ 36,976     $ 6,617     $ 30,846  
    

  


 


 


 


Equity in income (losses) of affiliates:

                                       

Lilly ICOS

   $ 19,519    $ (130,396 )   $ (87,320 )   $ (65,669 )   $ (38,219 )

Suncos

                140       (29,933 )     (15,200 )

ICOS-TBC

                      (8,558 )     (11,461 )

ICOS Clinical Partners

                            (22 )
    

  


 


 


 


     $ 19,519    $ (130,396 )   $ (87,180 )   $ (104,160 )   $ (64,902 )
    

  


 


 


 


 

28


Table of Contents
Item 7.   Management’s Discussion and Analysis of Results of Operations and Financial Condition

 

Our Management’s Discussion and Analysis of Results of Operations and Financial Condition should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report.

 

Overview

 

The following management discussion and analysis is intended to provide information which will enhance a reader’s understanding of our business, results of operations, financial condition and related matters. It is organized as follows:

 

    In the section entitled “ICOS Corporation Background,” we briefly describe our primary sources of revenue and cash, the importance of collaborations to our business, the business environment in which we operate, our approved product (Cialis) and our research and development programs.

 

    In “Results of Operations,” we discuss each of our most critical accounting policies as well as the primary factors that are likely to contribute to significant variability of our results of operations from period to period. We then provide detailed narrative regarding significant changes in our and Lilly ICOS’ results of operations for 2005 compared to 2004, and 2004 compared to 2003.

 

    Under the section entitled “Liquidity and Capital Resources,” we discuss our 2005 year-end liquidity, our cash flows for the year ended December 31, 2005, compared to those for the year ended December 31, 2004, factors that may influence our future cash requirements and the status of certain contractual obligations as of December 31, 2005.

 

    In the section entitled “2006 Required Accounting Change,” we discuss changes in our accounting for share-based payment transactions, particularly stock options. These changes are required to be implemented during our 2006 first quarter.

 

    Finally, under “Legal Proceedings,” we discuss the status of certain litigation relating to Cialis.

 

ICOS Corporation Background

 

ICOS Corporation is a biotechnology company that is dedicated to bringing innovative therapeutic products to patients. Through Lilly ICOS, we are marketing Cialis (tadalafil) for the treatment of erectile dysfunction. Directly or through Lilly ICOS, we are also working to develop and commercialize treatments for serious unmet medical needs such as BPH, PAH, hypertension, cancer and inflammatory diseases.

 

We recognize revenue for services we provide, under sales and marketing, research and development, contract manufacturing and co-promotion agreements, and for amounts earned from licensing of our technology. The majority of our revenue relates to cost reimbursement for sales and marketing and research and development activities that we conduct on behalf of Lilly ICOS. Our sources of cash include, among other items, distributions to be received based on the profitability of Lilly ICOS and amounts earned from the aforementioned revenue sources.

 

The discovery and development of a new drug product is a rigorous process, involving a significant degree of risk. Since the underlying biology of many diseases is not completely understood, it is very difficult to discover and develop a drug that can withstand the extensive preclinical and clinical testing necessary to demonstrate its safety and efficacy in humans. As a result, very few research and development projects result in a commercially approved product. Our long-term business growth depends on our ability to successfully develop and commercialize important new therapeutic treatments, which may include potential new indications for tadalafil, the active ingredient in Cialis.

 

29


Table of Contents

Over the years, we have established collaborations with pharmaceutical and biotechnology companies to enhance our internal development capabilities, to acquire rights to additional product candidates, to gain access to the capabilities of our collaboration partners and to offset a substantial portion of the financial risk of developing individual product candidates. Our most significant ongoing collaboration is Lilly ICOS. We expect to establish additional collaborations with pharmaceutical and other biotechnology companies in the future.

 

We operate in a highly regulated business environment. Cialis and our product candidates require extensive regulatory review, approval and oversight prior to commercialization. For example, the FDA regulates, among other things, the development, manufacture, approval, advertising, promotion, sale and distribution of pharmaceutical products. Our products marketed abroad are also subject to extensive regulation by foreign governments. The regulatory processes are lengthy, expensive and uncertain. They may take years to complete, may involve ongoing requirements for post-marketing studies and can affect the nature, content, timing and cost of our marketing efforts.

 

The markets in which we compete are well established and intensely competitive. Cialis and our product candidates, if approved and commercialized, compete or are likely to compete against existing therapeutic products or treatments. In addition, a number of pharmaceutical and biotechnology companies are currently developing products targeting the same diseases and medical conditions that we target. Key factors affecting our markets include: the timing and scope of regulatory approvals; safety and efficacy of therapeutic products; cost and availability of these products; availability of alternative treatments; and protection of patent and proprietary rights. Although, we believe that we are positioned to compete adequately with respect to these factors in the future, our future success is currently difficult to predict. Cialis has only been available in Europe since February 2003 and in North America since November 2003. Our product candidates are in various stages of research and development and, accordingly, subject to substantial research, development, regulatory approval and commercialization risks. Since timing of market entry can be an important factor in determining a new product’s eventual success and profitability, the speed with which we can develop products and receive regulatory approval will likely be important to our commercial success.

 

Cialis (tadalafil)

 

Our first commercial product, Cialis, is being prescribed around the world for patients with erectile dysfunction. Cialis is being manufactured and marketed by Lilly ICOS, which has rights to commercialize Cialis in North America and Europe. Lilly has exclusive rights to market Cialis in the remainder of the world, and pays royalties to Lilly ICOS, equal to 20% of the net sales in those territories. Sales of Cialis are recorded by Lilly ICOS or Lilly depending upon the territory in which the sales occur.

 

Overall growth in market demand for erectile dysfunction drugs, and Lilly ICOS’ ability to capture and retain increased market share, will significantly affect revenues and expected profitability from Cialis and, in turn, our results of operations and cash flows. Cialis sales have experienced steady overall growth and we have continued to gain market share since the drug’s launch in 2003. Worldwide sales of Cialis increased 35% in 2005, to $746.6 million, compared to $552.3 million in 2004. For the month of December 2005, Cialis U.S. market share was 25.0%, compared to 20.0% in the same month of the prior year. In Europe, Canada and Mexico, Cialis’ aggregate market share for December 2005 was 33.2%, an increase of 4.2 percentage points compared to December 2004.

 

Lilly ICOS is currently evaluating tadalafil for potential use in indications other than erectile dysfunction. In 2005, Lilly ICOS completed a Phase 2 clinical study and reported positive results in the treatment of lower urinary tract symptoms in men with BPH. Lilly ICOS plans to proceed with a Phase 2b BPH clinical study in 2006, which may serve as one of two pivotal studies, to evaluate multiple doses of tadalafil in patients with BPH. The results of the multi-dose study will be useful in the design of a Phase 3 study, expected to begin in 2008. Lilly ICOS also initiated a Phase 3 clinical study, in August 2005, evaluating tadalafil for the treatment of PAH, and a Phase 2 clinical study, in September 2005, for the treatment of mild to moderate hypertension.

 

30


Table of Contents

Discovery and Preclinical Research

 

We are continuously evaluating possible new product candidates in our discovery and preclinical research programs. The following table summarizes those programs.

 

     
  Therapeutic Area    Indication    Status
  Inflammation    Psoriasis, Asthma    Preclinical
  Urology    Overactive bladder    Preclinical
  Oncology    Non-small cell lung cancer/others    Preclinical, Research
  Fibrotic diseases    Kidney disease    Research

 

In the status column of the above table: “Preclinical” indicates evaluation of lead or preferred compounds or antibodies for safety, pharmacology and proof of efficacy in non-human animal models; and “Research” indicates the identification process for compounds or antibodies for which activity in target human biological assay systems has been demonstrated in laboratory tests, but which have not yet been tested in non-human animal models of specific human diseases.

 

Discontinued Product Candidates

 

In March 2005, we announced that a Phase 2 study of IC485, a phosphodiesterase type 4 enzyme (PDE4) inhibitor we were evaluating for the treatment of chronic obstructive pulmonary disease, did not meet the primary endpoint of improved lung function. We have no plans for further development of IC485.

 

In 2003, we completed patient follow-up in a Phase 2 clinical study evaluating resiniferatoxin (RTX) for the treatment of interstitial cystitis and, in January 2004, determined that RTX was not effective in relieving patients’ symptoms.

 

IC14, a monoclonal antibody, was evaluated as a treatment for sepsis resulting from community acquired pneumonia. In the fourth quarter of 2003, we concluded that the results of a Phase 2 clinical study did not meet our criteria to continue further investment.

 

In 2003, we concluded our LFA-1 antagonist collaboration with Biogen IDEC, Inc. (Biogen), and reacquired sole development rights to the program. Through our medicinal chemistry efforts, we have identified follow-on LFA-1 antagonists, with improved properties, which are now in advanced stages of preclinical testing.

 

In January 2003, we announced that joint development of endothelin receptor antagonists, through ICOS-Texas Biotechnology L.P. (ICOS-TBC), would not continue. On April 22, 2003, Encysive Pharmaceuticals acquired all of our interests in ICOS-TBC for $10.0 million.

 

Results of Operations

 

Critical Accounting Policies and Estimates

 

Our critical accounting policies include revenue recognition, accounting for our share of the operating results of our unconsolidated affiliates (presently only Lilly ICOS) and estimating expenses from contracted research and clinical study activities conducted by various third parties.

 

31


Table of Contents

Revenue Recognition

 

Collaboration revenue

 

We recognize revenue from our contracts for research, development, marketing and sales services as the related billable time and costs are incurred. Payments received, related to future performance, are deferred and recognized as revenue when the future performance occurs.

 

Contract manufacturing

 

Contract manufacturing revenue, including fees earned for process development and manufacturing services performed for third parties, is recognized when collectibility is reasonably assured and the manufacturing obligation is fulfilled or manufacturing services are performed, as appropriate, based on the terms of the agreement. Payments received in excess of amounts earned are recorded as deferred revenue.

 

Co-promotion services

 

Co-promotion services revenue represents fees earned for physician details (sales calls) and other activities related to our promotion of others’ products. We recognize this revenue, at contractual rates, as the specified services are provided.

 

Licenses of technology

 

Nonrefundable upfront technology license fees, for product candidates where we are providing continuing services related to product development, are deferred, and recognized as revenue as we provide the services required under the agreement. We recognize nonrefundable upfront technology fees as revenue based on the ratio of current development costs to total estimated current and future development costs through the date we expect to file a New Drug Application (NDA), or an equivalent, with the FDA. We believe this method appropriately matches revenue with the estimated costs of the development effort. We also believe that development costs are the best available surrogate for benefits obtained as data is collected and other research and development activities progress related to the licensed technology.

 

We estimate the total projected development costs based on the specific terms of each agreement, our judgment and experience and, when appropriate, the expertise of our collaboration partners. The ability to estimate total development effort and costs can vary significantly for each product candidate due to the inherent complexities and uncertainties of drug development. In the past, we have been able to estimate total expected development costs, for certain product candidates, because they were in later stages of clinical development at the time such estimates were prepared or our partner had substantial previous experience in the relevant field of study. However, we may not be able to reasonably estimate total expected development costs for product candidates in the future, particularly if such product candidates are in earlier stages of clinical development. To the extent we cannot estimate the costs to complete development, but can estimate an expected NDA filing date, we will recognize license fee revenue ratably through the expected NDA filing date. If we are unable to reasonably estimate either total costs to complete development or an expected NDA filing date (performance period), we will defer revenue recognition until one of those estimates can be made or the project is discontinued.

 

Milestones, in the form of additional license fees, typically represent nonrefundable payments to be received in conjunction with the achievement of a specific event identified in the contract, such as initiation or completion of specified clinical development activities. We believe that a milestone represents the culmination of a distinct earnings process when it is not associated with ongoing research, development or other performance on our part. We recognize such milestones as revenue when they become due and collectibility is reasonably assured. When a milestone does not represent the culmination of a distinct earnings process, we recognize revenue at the time such payments are due, provided collectibility is reasonably assured, based on the ratio of effort to date (in terms

 

32


Table of Contents

of costs or time, as discussed above) to total estimated development effort. Any remaining balance is deferred and recognized as revenue over the estimated remaining product development period, in the same manner as our upfront technology license fees.

 

The timing and amount of revenue that we recognize from licenses of technology, either from upfront fees or milestones where we are providing continuing services related to product development, is dependent upon our estimates of total product development effort as well as the timing of such effort over the estimated development period. As product candidates move through the development process, it is necessary to revise these estimates to consider changes to the product development cycle, such as changes in the clinical development plan, regulatory requirements, or various other factors, many of which may be outside of our control. The impact on revenue of changes in our estimates and the timing thereof, is recognized prospectively, over the remaining estimated product development period.

 

Accounting for our Share of the Operating Results of our Unconsolidated Affiliates

 

We recognize our share of the operating results of our unconsolidated affiliates, in proportion to our ownership interest in the affiliate, and report it as equity in income (losses) of affiliates. Losses relating to our affiliates are recognized only to the extent we have made, or are committed to make, capital contributions to the affiliate. Operating results of our affiliates include expenses related to research, development, marketing and sales services that we provide to them, and that we recognize as collaboration revenue. The amount of our collaboration revenue, and the associated costs, both depend on continued research and development activities, the extent and timing of marketing and sales activities, and our level of participation in those activities. A shift of research, development or co-promotional activities among collaboration partners could have a significant impact on our overall operating results to the extent that our collaboration billing rates include indirect and overhead costs that may not vary based on our collaboration activities. Also, a shift of such activities could have a material impact on our costs and expenses and the consequent amount of our collaboration revenue. For example, a shift of development activities from ICOS to our collaboration partner would result in our reporting lower revenue and lower operating expenses, though not necessarily of equal amounts.

 

Estimating Expenses from Contracted Research and Clinical Study Activities

 

Some of our research and development, including certain clinical study activities, is conducted by third parties, including contract research organizations, which may also provide contractually defined administration and management services. We recognize expenses for these contracted activities based on a variety of factors, including actual and estimated labor hours, clinical site initiation activities, patient enrollment rates, estimates of external costs and other activity-based factors. On a regular basis, our estimates of these costs are reconciled to actual invoices from the service providers, and adjustments are made accordingly.

 

Management Estimates and Assumptions

 

The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Modifications to these assumptions could result in estimates that are substantially different from those reflected in our financial statements.

 

General

 

Our results of operations may vary significantly from period to period. Operating results will depend on, among other factors: market demand and competition for our product, Cialis, and other products marketed by us or our affiliates; the timing, cost and success of new product launches (or launches of existing products for use in

 

33


Table of Contents

new indications) by us or our affiliates; the timing and magnitude of other operating expenses, including expenses of Lilly ICOS; the level of funding by collaboration partners; and the nature, timing and progression of research, development, marketing, sales and contract manufacturing activities. We may experience significant fluctuations in collaboration revenue, revenue from licenses of technology and contract manufacturing revenue. Collaboration revenue will vary depending upon the timing and amount of marketing and sales activities, the extent and timing of research and development collaboration activities, and our level of participation in those activities. Revenue from licenses of technology will vary as a result of (i) the nature and extent of product collaboration and other licensing transactions, (ii) the timing of milestone payments, and (iii) changes in estimated development costs and/or expected completion dates, which depend on the success of clinical studies and other research and development efforts. Contract manufacturing revenue may fluctuate depending upon our needs to manufacture our own internal product candidates, our ability to attract third parties to utilize any remaining manufacturing capacity and the particular terms and nature of the manufacturing agreements. Collaboration activities, including both research and development programs and activities associated with commercialized products, are subject to the joint oversight of the collaborating parties.

 

Year Ended December 31, 2005 Compared With Year Ended December 31, 2004

 

Revenue

 

Total revenue was $71.4 million in 2005, compared to $74.6 million in 2004.

 

Collaboration revenue from related parties was $50.1 million in 2005, compared to $56.0 million in 2004. The decrease primarily reflects a reduction in Lilly ICOS’ reimbursement of the costs of our sales force promoting Cialis, partially offset by higher revenue for research and development activities conducted on behalf of Lilly ICOS. From September 2003 through December 2004, the costs of our sales force were fully reimbursed by Lilly ICOS. Beginning in January 2005, 60% of the costs of our sales force are being reimbursed by Lilly ICOS. Beginning in January 2006, our collaboration revenue from Lilly ICOS will also include full reimbursement for the cost of 40 third party sales representatives that we have engaged to promote Cialis in the United States.

 

Contract manufacturing revenue was $16.0 million in 2005, compared to $16.4 million in 2004. Revenue associated with our contract manufacturing services may fluctuate significantly based on our internal manufacturing needs and our ability to sell excess capacity to third parties.

 

Co-promotion services revenue, whereby we received a fee per sales call to promote AndroGel® on behalf of Solvay Pharmaceuticals, Inc., totaled $5.3 million in 2005. The co-promotion arrangement ended in December 2005.

 

Revenue for 2004 included $2.2 million from licenses of technology to third parties who are independently developing products that use ICOS technology.

 

Equity in Income (Losses) of Affiliates

 

Our equity in income of Lilly ICOS was $19.5 million in 2005, compared to equity in losses of $130.4 million in 2004. See Lilly ICOS Results of Operations later herein.

 

Operating Expenses

 

Total operating expenses were $165.2 million in 2005, compared to $142.0 million in 2004.

 

Research and development.    Research and development expenses are principally comprised of costs for: personnel, including salaries and benefits; occupancy; clinical studies performed by third parties; materials and

 

34


Table of Contents

supplies to support our programs; contract research; manufacturing; consulting arrangements; in-licensing fees; and other expenses incurred to operate our research and development programs.

 

Research and development expenses increased $16.5 million, to $88.3 million in 2005. The increase was primarily due to higher expenses associated with our discovery and preclinical research programs and incremental development activities being performed by ICOS personnel on behalf of Lilly ICOS, partially offset by the impact of the discontinuation of IC485 development activities in the 2005 first quarter.

 

Our research and development activities occur in two main areas: (i) discovery and preclinical research; and, (ii) clinical research and development, including the formulation and manufacture of drug substance for use in clinical studies and, when appropriate, seeking approval for commercial manufacturing and marketing.

 

Our discovery and preclinical research focuses on the identification and initial testing of new product candidates. During this stage, we identify new drug targets and lead compounds, and then optimize their characteristics through repetitive cycles of chemical modification. Compounds that demonstrate the most attractive characteristics and that appear to offer the potential for therapeutic benefit are subsequently evaluated in laboratory preclinical studies to evaluate their safety, pharmacology and efficacy in animal models. Based on the results of preclinical studies, specific compounds may be selected to advance to clinical research and development.

 

Clinical research and development refers to internal and external activities associated with clinical studies in humans and advancing clinical product candidates towards a goal of seeking regulatory marketing approval. Such activities include, among other things, services provided by clinical research organizations and principal investigators and concurrent activities associated with advancing a clinical product candidate, such as the manufacture and formulation of drug compounds for clinical studies and in preparation for commercial scale production. The clinical development process involves several rigorous stages, many of which are strictly prescribed and monitored by regulatory authorities, such as the FDA.

 

Our clinical research and development expenses include the costs of activities that are not attributable to individual projects, but are necessary to support our overall clinical program. These “indirect” costs are primarily associated with general regulatory compliance, staff training, development and maintenance of clinical processes and information systems, management and administrative support. These indirect costs are not allocated to development projects.

 

The following table provides information regarding our research and development expenses, by project:

 

     Year Ended December 31,

     2005

   2004

   2003

     (In thousands)

Cialis (tadalafil)

   $ 19,332    $ 12,959    $ 6,657

Discontinued clinical projects:

                    

IC485

     3,425      12,045      9,441

RTX

          1,288      9,862

IC14

          350      7,203

IC747

               4,043

Other

               2,938

Indirect clinical costs

     7,528      7,157      8,232

Discovery and preclinical research

     58,004      37,992      37,382
    

  

  

Total research and development expenses

   $ 88,289    $ 71,791    $ 85,758
    

  

  

 

Development of a new drug product is a lengthy and expensive process, involving a high degree of uncertainty. Very few research and development projects result in a commercial product. Before obtaining

 

35


Table of Contents

regulatory approval for the sale of any of our potential products, we must subject them to extensive preclinical and clinical testing to demonstrate their safety and efficacy in humans. At any time during the multi-year clinical development period, factors such as ineffectiveness of the product candidate, discovery of unacceptable toxicities or side effects, development of disease resistance or other physiological factors, or delays in patient enrollment or other development activities could cause us to interrupt, limit, delay or abort the development of a product candidate. Because of the uncertainties of clinical research and development, at this time we are unable to provide estimates of project completion dates, the timing of our research and development efforts and costs of completing research and development projects.

 

Various statutes and regulations govern or influence the manufacturing, safety, labeling, storage, record keeping, marketing and other factors that are critical in the development and commercialization of a product candidate. The lengthy process of complying with the applicable statutes and regulations and seeking necessary regulatory approvals requires the expenditure of substantial resources. Any failure by us to obtain, or any delay in obtaining regulatory approvals, could have a material adverse effect on our business.

 

A substantial delay in completing clinical studies or obtaining regulatory approvals could severely harm our business. Such delays could: require that we spend substantial additional funds to continue our development efforts; delay, for a considerable period of time, our ability to seek or obtain regulatory approvals needed to market our potential products; and, provide existing or new competitive products with the opportunity to expand their share or enter the market before ours. These, and similar events, could have a material adverse effect on our ability to bring a product to market, substantially increasing the cost of development and postponing, reducing or eliminating the potential to generate net cash inflows from the successful commercialization of a product.

 

Marketing and selling.    Marketing and selling expenses principally consist of costs associated with our pharmaceutical sales force, marketing activities for Cialis that we conduct on behalf of Lilly ICOS and market research activities for our product candidates in research and development. Marketing and selling expenses increased $3.2 million, to $42.6 million in 2005. The increase was primarily due to increased sales force compensation costs and incremental costs associated with our co-promotion arrangement with Solvay Pharmaceuticals, Inc.

 

Cost of contract manufacturing.    Contract manufacturing expenses are principally comprised of costs for: personnel, including salaries and benefits; occupancy; raw materials and consumables used in process development and manufacturing; testing services provided by third parties; facility overhead, including taxes, depreciation, utilities and maintenance of manufacturing equipment; and other shared services, including information systems and staff support.

 

General and administrative.    General and administrative expenses consist primarily of costs associated with corporate support functions, general management and other activities not related to research and development, marketing and sales or contract manufacturing. General and administrative expenses were $20.3 million in 2005 and $18.2 million in 2004. The increase primarily reflects higher legal expenses, costs associated with the issuance of restricted stock awards in the 2005 third quarter and other compensation increases.

 

Interest Expense

 

In both 2005 and 2004, we incurred $6.8 million of interest expense (including $1.2 million of amortization of deferred financing costs), on $278.7 million of 2% convertible subordinated notes, issued in June and July of 2003.

 

Interest and Other Income

 

Interest and other income totaled $6.2 million in 2005, compared to $6.4 million in 2004, reflecting lower average invested balances during 2005, partially offset by higher average interest rates earned.

 

36


Table of Contents

Lilly ICOS Results of Operations

 

Lilly ICOS reported net income of $37.8 million in 2005, compared to a net loss of $262.0 million in 2004. The $299.8 million improvement reflects increased worldwide sales of Cialis and reductions in selling, general and administrative expenses in 2005.

 

Worldwide sales of Cialis for 2005 and 2004 were as follows:

 

     Year Ended
December 31,


     2005

   2004

     (In millions)

Lilly ICOS territories:

             

United States

   $ 272.9    $ 206.6

Europe

     244.5      177.9

Canada and Mexico

     59.3      37.2
    

  

Total Lilly ICOS

     576.7      421.7

Lilly territories

     169.9      130.6
    

  

Worldwide total

   $ 746.6    $ 552.3
    

  

 

Total Lilly ICOS revenue, in 2005, was $610.7 million, including $34.0 million in royalties on Cialis sales in the Lilly territories, compared to $447.9 million, including $26.1 million in royalties in 2004. Revenue for 2005 was negatively affected by the impact of approximately $27.0 million in aggregate reductions of U.S. wholesaler inventories of Cialis during the 2005 first quarter.

 

Cialis has continued to capture a significant share of the PDE5 inhibitor market since its launch in 2003. For the month of December 2005, based on prescriptions filled, Cialis had a 25.0% market share in the United States.1 For the major Lilly ICOS territories outside of the United States, based on pharmacy purchases from wholesalers, Cialis market share for December 2005 ranged from 26% in the United Kingdom to 48% in France.2

 

Cost of sales totaled $47.3 million in 2005, including royalties payable by Lilly ICOS equal to 5% of its net product sales. Cost of sales was 8.2% of net product sales in 2005 and 8.6% of net product sales in 2004.

 

Selling, general and administrative expenses include costs associated with conducting in-person sales calls with physicians; marketing activities, including advertising, physician congresses and symposia, market research, public relations; and finance and legal costs. Selling, general and administrative expenses decreased $146.7 million from 2004, to $459.8 million in 2005. The decrease primarily reflects planned reductions in U.S. selling and marketing expenses. During 2004, we made significant launch-related investments in sales and marketing programs to communicate the unique benefits of Cialis to consumers and prescribing physicians.

 

Research and development expenses are principally comprised of costs for hourly-based fees for services provided by Lilly and ICOS; clinical studies performed by third parties; materials and supplies to support clinical programs; and other expenses incurred to support Lilly ICOS’ overall research and development program. Research and development expenses were $65.8 million in 2005, compared to $67.3 million in 2004.

 

Year Ended December 31, 2004 Compared With Year Ended December 31, 2003

 

Revenue

 

Total revenue was $74.6 million in 2004, compared to $75.1 million in 2003.

 


1 IMS National Prescription Audit Plus, December 2005.
2 IMS Health. IMS MIDAS, Copyright 2006.

 

37


Table of Contents

Collaboration revenue from related parties was $56.0 million in 2004, compared to $25.9 million in 2003. The increase reflects higher revenue from Lilly ICOS, primarily reimbursement of costs associated with our sales force promoting Cialis in the United States for all of 2004. Beginning in September 2003, and continuing through December 2004, the costs of our sales force and the costs of marketing Cialis in the United States were fully reimbursed by Lilly ICOS.

 

Contract manufacturing revenue was $16.4 million in 2004, compared to $12.2 million in 2003. The increases reflect greater use of our manufacturing capacity for external business during 2004, compared to the prior year.

 

Revenue from licenses of technology was $2.2 million in 2004, compared to $37.0 million in 2003. The 2004 license fee revenue represents amounts due from third parties who are independently developing products that use technology licensed from ICOS. Included in the 2003 technology license fee revenue is $21.3 million of previously deferred upfront fees and forgiven loans, received from Biogen, which we recognized as revenue in conjunction with our reacquisition of sole development rights to the LFA-1 antagonist program in June 2003. Revenue from licenses of technology for 2003 also included $15.0 million earned upon the first commercial sale of Cialis in the United States.

 

Equity in Income (Losses) of Affiliates

 

Our equity in losses of affiliates was $130.4 million in 2004, compared to $87.2 million in 2003. See Lilly ICOS Results of Operations later herein.

 

Operating Expenses

 

Total operating expenses were $142.0 million in 2004, compared to $130.5 million in 2003.

 

Research and development.    Research and development expenses decreased $14.0 million, to $71.8 million in 2004. The decrease was primarily due to discontinuation of activities associated with the RTX, IC14 and IC747 programs. Those decreases were partially offset by increased costs related to activities associated with the development of IC485 and incremental Lilly ICOS research and development activities being performed by ICOS personnel in 2004.

 

Marketing and selling.    Marketing and selling expenses increased $19.6 million, to $39.4 million in 2004. The increase reflects costs associated with our U.S. sales force, which was hired and initially deployed in the third quarter of 2003.

 

Cost of contract manufacturing.    Contract manufacturing expenses increased $2.9 million, to $12.6 million in 2004. The increase primarily reflects greater use of capacity for external business during 2004, compared to 2003.

 

General and administrative.    General and administrative expenses were $18.2 million in 2004 and $15.3 million in 2003. The increase reflects cash executive performance incentive awards for 2004, compared to stock option executive incentive awards for previous years. The increase also reflects incremental professional fees, including legal, accounting and auditing, and recruiting.

 

Interest Expense

 

In 2004 and 2003, we incurred $6.8 million and $3.6 million of interest expense (including $1.2 million and $0.6 million, respectively, of amortization of deferred financing costs), on $278.7 million of 2% convertible subordinated notes, issued in June and July of 2003.

 

38


Table of Contents

Interest and Other Income

 

Interest and other income totaled $6.4 million in 2004, compared to $10.0 million in 2003. The decrease primarily reflects lower average investment balances during 2004, partially offset by higher average interest rates earned.

 

Lilly ICOS Results of Operations

 

Lilly ICOS reported a net loss of $262.0 million in 2004, compared to a net loss of $174.7 million in 2003.

 

Worldwide sales of Cialis for 2004 and 2003 were as follows:

 

     Year Ended
December 31,


     2004

   2003

     (In millions)

Lilly ICOS territories:

             

United States

   $ 206.6    $ 27.9

Europe

     177.9      95.1

Canada and Mexico

     37.2      6.8
    

  

Total Lilly ICOS

     421.7      129.8

Lilly territories

     130.6      73.5
    

  

Worldwide total

   $ 552.3    $ 203.3
    

  

 

Total Lilly ICOS revenue, in 2004, was $447.9 million, including $26.1 million in royalties on Cialis sales reported by Lilly, compared to $144.5 million, including $14.7 million in royalties in 2003.

 

Cost of sales totaled $36.1 million in 2004, including royalties payable by Lilly ICOS equal to 5% of its net product sales. Cost of sales was 8.6% of product sales in 2004, and 9.7% of product sales in 2003.

 

Selling, general and administrative expenses increased $363.4 million over the prior year, to $606.5 million in 2004. The increase primarily reflects higher 2004 selling and marketing costs due to the timing of launches of Cialis in the United States, Canada and Mexico.

 

Liquidity and Capital Resources

 

At December 31, 2005, we had cash, cash equivalents, investment securities and associated interest receivable of $162.8 million, compared to $275.8 million at December 31, 2004. The decrease primarily reflects our 2005 net cash used in operations and funding of our investment in Lilly ICOS.

 

We used $76.0 million in cash for operating activities during 2005, compared to $54.2 million during 2004. This change primarily reflects a higher 2005 operating loss, before equity in undistributed income (losses) of Lilly ICOS. During the 2005 fourth quarter, we received a $6.6 million distribution from Lilly ICOS based on its net income in the previous quarter. Future distributions are expected to occur based on Lilly ICOS’ ongoing profitability and cash requirements.

 

We generated $66.5 million in cash from investing activities during 2005, compared to $27.2 million in 2004. Capital contributions to Lilly ICOS totaled $36.8 million in 2005, reflecting funding of Lilly ICOS’ operations through the 2005 second quarter, compared to $140.4 million in the year ended December 31, 2004. We decreased our investment portfolio in 2005 and 2004, resulting in net cash inflows of $108.2 million and $167.4 million, respectively. The net decrease in our investment portfolio reflects investment sales and maturities used to fund operations and capital contributions to Lilly ICOS. Cash inflows from investing activities in 2004 also included $6.0 million in proceeds from the sale of our partnership interests in ICOS-TBC.

 

39


Table of Contents

Net cash from the exercise of stock options, totaled $6.8 million and $7.0 million in 2005 and 2004, respectively. We issued approximately 0.6 million shares of our common stock upon the exercise of stock options in both 2005 and 2004.

 

Our existing cash and cash equivalents, investment securities, interest income from our investments, distributions of expected profits from Lilly ICOS, and cash flow from potential future collaborations, are believed to be sufficient to fund our operations for at least the next twelve months. However, in view of (i) the fact that Lilly ICOS only recently became profitable, (ii) our ongoing research and development efforts, and (iii) potential expansion of our operations through in-licensing, collaborations or acquisitions, it is possible that we may need to seek additional financing. Additional financing may not be available when we need it or may be unavailable on acceptable terms. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures for some of our marketing and selling activities or our research and development programs, or grant rights to third parties to develop and market product candidates that we would prefer to develop and market on our own.

 

Our future cash requirements will depend on various factors which, to some extent, are beyond our control, including:

 

    continued successful commercialization of Cialis throughout the world;

 

    funding levels for research and development programs, including continued funding from our collaboration partners;

 

    the results, timing and extent of preclinical and clinical studies;

 

    the time and costs involved in filing and prosecuting patents and enforcing and defending patent claims;

 

    the regulatory process in the U.S. and other countries;

 

    acquisitions of products, technologies or businesses, if any;

 

    relationships with research and development collaborators;

 

    capital contributions to our affiliates;

 

    capital expenditures for property, plant and equipment;

 

    competing technological and market development activities; and

 

    the time and costs of manufacturing, scale-up and commercialization activities.

 

We have engaged in collaborations and joint development agreements with other parties where the capabilities and strategies of the other parties complement ours. Depending on the specific terms of our collaborative agreements, we may record revenue to the extent we are reimbursed for services we provide on behalf of a jointly owned entity. For example, we record collaboration revenue for research, development, marketing and sales services we provide to or on behalf of Lilly ICOS. Although collaborations, partnerships and joint ventures have provided revenue to us in the past, we cannot assure you that this type of revenue will be available to us in the future.

 

We intend to expand our operations and portfolio of product candidates in clinical studies, as well as to continue discovery and preclinical research to identify additional product candidates. We also intend to continue to engage in pre-marketing activities necessary to bring our product candidates to market and to expand

 

40


Table of Contents

marketing and selling capabilities for our approved product. Due to the uncertainties of drug development and commercialization, as discussed elsewhere herein, we are unable to determine if, or when, any of our current product candidates will begin to generate net cash inflows.

 

In the future, we may pursue new growth opportunities in a variety of ways including, but not limited to, internal discovery and development of new products, in-licensing of products and technologies and/or merger or acquisition of companies with desirable products and/or technologies. Expansion of our operations will increase our future operating expenses. Furthermore, we may need to make incremental expenditures for additional laboratory, production and office facilities to accommodate the activities and personnel associated with these increased development and commercialization efforts. Any of these activities may require substantial capital investment.

 

Our operating cash flows include the effect of certain noncancelable, contractual obligations. A summary of our contractual obligations, as of December 31, 2005, is as follows:

 

     Payments Due By Period

     (In thousands)
     Less than
1 year


   1 to 3
years


   4 to 5
years


   More than
5 years


   Total

Convertible subordinated debt and related interest payments

   $ 5,573    $ 11,146    $ 287,010    $    $ 303,729

Operating leases

     6,982      10,855      1,715      463      20,015
    

  

  

  

  

     $ 12,555    $ 22,001    $ 288,725    $ 463    $ 323,744
    

  

  

  

  

 

Convertible subordinated debt and related interest payments:    In 2003, we issued $278.7 million of convertible subordinated notes, which accrue interest at 2% per annum, payable semiannually on January and July 1. The notes mature on July 1, 2023 and are unsecured, subordinated to any senior indebtedness, and convertible, at the option of the holder, into our common stock at a conversion price of $61.50 per share, subject to adjustment in certain circumstances. Note holders may require us to purchase, for cash, all or a portion of their notes on July 1, 2010, 2013 or 2018, at a price equal to the principal amount of the notes being repurchased. We may redeem all or a portion of the notes, at par, for cash at any time on or after July 5, 2010.

 

Operating leases:    We lease certain property and equipment under operating leases which, in the aggregate, obligate us through 2012. Many of our leases contain renewal options and provide for escalations of rent and payment of real estate taxes, maintenance, insurance and certain other operating expenses of the properties.

 

In addition to the contractual obligations noted above, we have entered into various licensing and research and development arrangements under which we may be obligated to make future payments to third parties upon the achievement of certain success-based objectives. We also have entered into contracts with various third parties, under which we may be required to pay immaterial amounts in the event of contract termination.

 

In connection with our acquisition of technology rights to certain PDE5 inhibitors, including tadalafil, we committed to pay a third party a royalty equal to 5% of the net sales of products developed utilizing the acquired technology. Lilly ICOS and Lilly have accepted primary responsibility for the royalty obligations resulting from this arrangement.

 

Commitments

 

Based on the terms of our marketing and sales agreement with Lilly ICOS and Lilly, beginning in 2007, we may be required to assume a portion of the sales and marketing responsibilities for Cialis in Canada, Mexico and Europe. As an alternative to deploying our own sales force, we may fulfill our sales and marketing responsibilities in those territories by contracting with Lilly or third parties. In the event we deploy our own sales force, we will be reimbursed in a manner similar to how we are reimbursed in the United States.

 

41


Table of Contents

Off-Balance Sheet Arrangements

 

In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from our use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use of our products or services; real estate and equipment leases, under which we may indemnify lessors against third-party claims relating to use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements with initial purchasers and underwriters of our securities, under which we may indemnify them against claims relating to their participation in the transactions.

 

The nature and terms of these indemnifications vary from contract to contract, and generally a maximum obligation is not stated. Because we are unable to estimate our potential obligation, and because management does not expect these indemnifications to have a material adverse effect on our consolidated financial position, results of operations or cash flows, no related liabilities are recorded at December 31, 2005. We hold insurance policies that mitigate potential losses arising from certain indemnifications and, historically, we have not incurred significant costs related to performance under these obligations.

 

2006 Required Accounting Change

 

Prior to January 1, 2006, we accounted for our stock-based compensation according to the provisions of APB No. 25 and related interpretations and did not recognize compensation expense for options granted to employees and non-employee directors with exercise prices equal to or in excess of the fair value of the underlying shares at the date of grant.

 

Effective January 1, 2006, FAS 123R requires us to measure the cost of employee services received in exchange for equity instruments, such as stock options or restricted stock, based on the grant-date fair-value of the awards. The associated cost must be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). FAS 123R also requires us to estimate forfeitures in calculating stock-based compensation expense, rather than recognizing the impact of the forfeitures as they occur, which was previously permitted.

 

We will implement FAS 123R, on a prospective basis, beginning in the 2006 first quarter. Prior year amounts will not be restated, and we will not record a cumulative effect adjustment upon adoption of FAS 123R.

 

Legal Proceedings

 

In October 2002, Pfizer Inc., Pfizer Limited, and Pfizer Ireland Pharmaceuticals filed a patent infringement lawsuit against ICOS, Lilly ICOS and Lilly in the United States District Court for the District of Delaware. Pfizer contends that the use, offering for sale, selling, manufacture or importing of Cialis, into the United States, for the treatment of erectile dysfunction by any of the defendants infringes claim 24 of Pfizer’s U.S. Patent No. 6,469,012 (or the Pfizer Patent), and seeks a declaratory judgment to that effect. Pfizer also seeks a permanent injunction, attorneys’ fees, costs and expenses. In January 2003, we and the other defendants filed an answer denying the central allegations of plaintiffs’ complaint and setting forth various affirmative defenses.

 

The U.S. Patent and Trademark Office (PTO) subsequently ordered the reexamination of the Pfizer Patent. Under the reexamination process, the PTO is required to reconsider the validity of the patent if substantial new questions of patentability are raised by any party including the PTO itself. The District Court stayed, or suspended, the patent infringement lawsuit, pending the outcome of the reexamination. Subsequently, Lilly ICOS and other parties filed several reexamination requests regarding the Pfizer Patent, which were merged with the PTO’s ordered reexamination. The first office action issued by the PTO rejected claim 24 of the Pfizer Patent.

 

42


Table of Contents

The Examiner rejected claim 24 on the basis that certain prior art rendered the claimed invention not new and therefore unpatentable under 35 U.S.C. §102(b), and obvious under the judicially created doctrine of obviousness-type double patenting. The Examiner did not accept any of the other arguments made in the then-pending petitions for reexamination. We later filed a new request for reexamination of claim 24, which was granted by the PTO. Lilly also filed a separate new request for reexamination of claim 24; however, this request was denied. On September 15, 2005, the PTO issued a second office action that rejected Pfizer’s arguments made in response to the first office action, reaffirmed the initial rejection of claim 24, and entered new grounds for rejecting claim 24. The September 15, 2005 office action also maintained the obviousness-type double patenting rejection of the other claims. On November 15, 2005, Pfizer filed its response to the September 15, 2005 office action. According to PTO procedure, the PTO should issue a further action, which may finalize the rejections of claim 24, withdraw the rejections of that claim, or allow an amended claim to be entered. Pfizer can challenge the result of a final office action within the PTO and subsequently in court.

 

Litigation is inherently unpredictable and the eventual outcome in a particular case is impossible to determine in advance. We believe that Pfizer’s suit lacks merit and intend to vigorously pursue our various defenses. If Pfizer were to prevail in its suit against us, however, we might be subject to substantial damages, prohibited from marketing Cialis for the treatment of erectile dysfunction in the United States, or required by Pfizer to enter into a licensing agreement to market Cialis in the United States. Any such adverse result could have a material adverse effect on our business, financial position, results of operations and cash flows.

 

On July 20, 2005, a lawsuit was filed against ICOS by Vanderbilt University in the United States District Court for the District of Delaware. Vanderbilt filed the lawsuit asserting that three of its researchers contributed to the conception of the inventions reflected in U.S. Patent Nos. 5,859,006 and 6,140,329. U.S. Patent No. 5,859,006 is ICOS’ patent claiming tadalafil and certain related compounds; U.S. Patent No. 6,140,329 is ICOS’ patent claiming the use of tadalafil and certain related compounds to treat erectile dysfunction. Tadalafil is the active ingredient in Cialis, which is marketed in North America by Lilly ICOS, which has an exclusive license to U.S. Patent Nos. 5,859,006 and 6,140,329. The Vanderbilt lawsuit requests that the Court direct the U.S. Commissioner of Patents and Trademarks to add the three individual researchers as co-inventors on these patents. ICOS timely filed a response to the complaint on September 9, 2005, denying the central allegations of Vanderbilt’s complaint and setting forth various affirmative defenses. While the Company is diligently evaluating Vanderbilt’s claims and seeking additional information, it currently believes that Vanderbilt’s claims lack merit and intends to defend the lawsuit vigorously. Because the suit is in its early stages, it is premature to assess what, if any, impact the lawsuit might have on our business, financial position, results of operations and cash flows.

 

Item 7A.   Quantitative and Qualitative Disclosures about Market Risk

 

At December 31, 2005, our financial instruments include cash, cash equivalents, marketable investment securities, receivables, accounts payable and convertible subordinated debt. We do not use derivative financial instruments in our investment portfolio. Our exposure to market risk for changes in interest rates relates primarily to our marketable investment securities and convertible subordinated debt. Because of the relatively short effective maturities of our investments, we do not expect interest rate fluctuations to materially affect the aggregate value of our financial assets. The fair value of our convertible subordinated debt is expected to change inversely to changes in interest rates. The fair value of our convertible subordinated debt also is expected to change as our stock price and the expected volatility of our stock price change. The fair value of our convertible subordinated debt was $225.8 million at December 31, 2005, with a carrying amount of $278.7 million at that date.

 

43


Table of Contents
Item 8.   Consolidated Financial Statements and Supplementary Data

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Reports of Independent Registered Public Accounting Firm

   45

Consolidated Balance Sheets at December 31, 2005 and 2004

   47

Consolidated Statements of Operations for the Years Ended December 31, 2005, 2004 and 2003

   48

Consolidated Statements of Stockholders’ Equity (Deficit) and Comprehensive Income (Loss) for the Years Ended December 31, 2005, 2004 and 2003

   49

Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003

   50

Notes to Consolidated Financial Statements

   51

 

SUPPLEMENTARY DATA

 

Balance sheets of Lilly ICOS LLC as of December 31, 2005 and 2004, and the related statements of operations, members’ equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2005, are included elsewhere in this report.

 

All other consolidated financial statement schedules have been omitted as the information is not required or the information required is included in the consolidated financial statements or the notes thereto.

 

44


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

ICOS Corporation:

 

We have audited the accompanying consolidated balance sheets of ICOS Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of ICOS Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of ICOS Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 1, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

/s/ KPMG LLP

 

Seattle, Washington

March 1, 2006

 

45


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

ICOS Corporation:

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (see Item 9A herein), that ICOS Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). ICOS Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that ICOS Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework, issued by COSO. Also, in our opinion, ICOS Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework, issued by COSO.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of ICOS Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 1, 2006 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KPMG LLP

 

Seattle, Washington

March 1, 2006

 

46


Table of Contents

ICOS CORPORATION

 

CONSOLIDATED BALANCE SHEETS

 

(In thousands, except share data)

 

     December 31,

 
     2005

    2004

 
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 10,023     $ 12,778  

Investment securities, at market value

     113,686       209,332  

Interest receivable

     1,241       1,607  

Receivable from Lilly ICOS

     14,300       15,053  

Prepaids and other

     5,274       7,334  
    


 


Total current assets

     144,524       246,104  

Investment securities, at market value

     37,832       52,052  

Investment in Lilly ICOS

     35,497        

Property and equipment, net

     17,995       19,206  

Deferred financing costs and other

     5,919       7,619  
    


 


     $ 241,767     $ 324,981  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                 

Current liabilities:

                

Accounts payable

   $ 3,307     $ 3,913  

Accrued payroll and benefits

     7,722       6,856  

Accrued clinical expenses

     1,604       2,708  

Accrued interest

     2,787       2,787  

Other accruals

     6,833       7,897  

Due to Lilly ICOS

           14,147  

Deferred revenue

     134       1,495  
    


 


Total current liabilities

     22,387       39,803  

Convertible subordinated debt

     278,650       278,650  

Stockholders’ equity (deficit):

                

Preferred stock, $.01 par value; 2,000,000 shares authorized; none issued

            

Common stock, $.01 par value; 100,000,000 shares authorized; 65,046,305 shares at December 31, 2005 and 63,633,417 shares at December 31, 2004, issued and outstanding

     650       636  

Additional paid-in capital

     819,339       794,311  

Unearned equity compensation

     (15,919 )      

Accumulated other comprehensive loss

     (777 )     (698 )

Accumulated deficit

     (862,563 )     (787,721 )
    


 


Total stockholders’ equity (deficit)

     (59,270 )     6,528  
    


 


     $ 241,767     $ 324,981  
    


 


 

See accompanying notes to consolidated financial statements.

 

47


Table of Contents

ICOS CORPORATION

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(In thousands, except per share data)

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Revenue:

                        

Collaboration revenue from related parties

   $ 50,055     $ 56,031     $ 25,943  

Contract manufacturing

     16,045       16,377       12,185  

Co-promotion services

     5,310              

Licenses of technology

           2,200       36,976  
    


 


 


Total revenue

     71,410       74,608       75,104  
    


 


 


Equity in income (losses) of affiliates

     19,519       (130,396 )     (87,180 )
    


 


 


Operating expenses:

                        

Research and development

     88,289       71,791       85,758  

Marketing and selling

     42,579       39,392       19,770  

Cost of contract manufacturing

     14,028       12,561       9,703  

General and administrative

     20,275       18,247       15,272  
    


 


 


Total operating expenses

     165,171       141,991       130,503  
    


 


 


Operating loss

     (74,242 )     (197,779 )     (142,579 )
    


 


 


Other income (expense):

                        

Gain on sale of partnership interests

                 10,000  

Interest expense

     (6,817 )     (6,824 )     (3,578 )

Interest and other income

     6,217       6,355       10,038  
    


 


 


Total other income (expense)

     (600 )     (469 )     16,460  
    


 


 


Loss before income taxes

     (74,842 )     (198,248 )     (126,119 )

Income tax recovery

                 612  
    


 


 


Net loss

   $ (74,842 )   $ (198,248 )   $ (125,507 )
    


 


 


Net loss per common share — basic and diluted

   $ (1.17 )   $ (3.13 )   $ (2.01 )
    


 


 


Weighted-average common shares outstanding — basic and diluted

     63,996       63,435       62,561  
    


 


 


 

See accompanying notes to consolidated financial statements.

 

48


Table of Contents

ICOS CORPORATION

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

AND COMPREHENSIVE INCOME (LOSS)

 

(In thousands, except shares)

 

   

Common

Stock
Shares


  Common
Stock


  Additional
Paid-in
Capital


  Unearned
Equity
Compensation


    Accumulated
Other
Comprehensive
Income (Loss)


    Accumulated
Deficit


    Total
Stockholders’
Equity
(Deficit)


 

Balances at December 31, 2002

  62,104,891   $ 621   $ 777,697   $     $ 3,280     $ (463,966 )   $ 317,632  

Comprehensive loss:

                                               

Net loss

                          (125,507 )     (125,507 )

Net unrealized losses on investment securities

                    (2,527 )           (2,527 )
   
 

 

 


 


 


 


Total comprehensive loss

                    (2,527 )     (125,507 )     (128,034 )

Issuance of common stock upon exercise of options

  908,145     9     8,695                       8,704  

Stock and non-employee option expense

          627                       627  
   
 

 

 


 


 


 


Balances at December 31, 2003

  63,013,036     630     787,019           753       (589,473 )     198,929  

Comprehensive loss:

                                               

Net loss

                          (198,248 )     (198,248 )

Net unrealized losses on investment securities

                    (1,451 )           (1,451 )
   
 

 

 


 


 


 


Total comprehensive loss

                    (1,451 )     (198,248 )     (199,699 )

Issuance of common stock upon exercise of options

  620,381     6     6,940                       6,946  

Stock and non-employee option expense

          352                       352  
   
 

 

 


 


 


 


Balances at December 31, 2004

  63,633,417     636     794,311           (698 )     (787,721 )     6,528  

Comprehensive loss:

                                               

Net loss

                          (74,842 )     (74,842 )

Net unrealized losses on investment securities

                    (79 )           (79 )
   
 

 

 


 


 


 


Total comprehensive loss

                    (79 )     (74,842 )     (74,921 )

Issuance of restricted stock

  818,400     8     18,032     (18,032 )                 8  

Issuance of common stock upon exercise of options

  594,488     6     6,857                       6,863  

Stock and non-employee option expense

          139     2,113                   2,252  
   
 

 

 


 


 


 


Balances at December 31, 2005

  65,046,305   $ 650   $ 819,339   $ (15,919 )   $ (777 )   $ (862,563 )   $ (59,270 )
   
 

 

 


 


 


 


 

See accompanying notes to consolidated financial statements.

 

49


Table of Contents

ICOS CORPORATION

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(In thousands)

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Cash flows from operating activities:

                        

Net loss

   $ (74,842 )   $ (198,248 )   $ (125,507 )

Adjustments to reconcile net loss to net cash used in operating activities:

                        

Equity in undistributed (income) losses of affiliates

     (12,880 )     130,396       87,180  

Depreciation and amortization

     6,171       5,494       6,227  

Amortization of deferred financing costs

     1,244       1,244       657  

Amortization of investment premiums, net

     1,593       3,892       5,367  

(Gain) loss on sale of investment securities, net

           22       (1,290 )

Gain on sale of partnership interests

                 (10,000 )

Technology license fee revenue (greater) less than amounts collected

     2,200       (2,200 )     (21,976 )

Stock and non-employee option expense

     2,252       352       627  

Changes in operating assets and liabilities:

                        

Receivables

     (144 )     1,672       (7,929 )

Other assets

     1,647       (1,014 )     (481 )

Accounts payable and accrued liabilities

     (3,269 )     4,223       (3,906 )
    


 


 


Net cash used in operating activities

     (76,028 )     (54,167 )     (71,031 )
    


 


 


Cash flows from investing activities:

                        

Purchases of investment securities

     (216,797 )     (445,429 )     (863,157 )

Maturities of investment securities

     71,374       99,864       181,537  

Sales of investment securities

     253,617       512,944       576,771  

Acquisitions of property and equipment

     (4,960 )     (5,731 )     (4,988 )

Proceeds from sale of partnership interests

           6,000       4,000  

Investments in affiliates

     (36,764 )     (140,423 )     (86,350 )
    


 


 


Net cash provided by (used in) investing activities

     66,470       27,225       (192,187 )
    


 


 


Cash flows from financing activities:

                        

Proceeds from stock options

     6,803       6,991       8,656  

Borrowings under line of credit

                 4,308  

Proceeds from issuance of convertible subordinated debt, net of related costs

                 269,940  
    


 


 


Net cash provided by financing activities

     6,803       6,991       282,904  
    


 


 


Net increase (decrease) in cash and cash equivalents

     (2,755 )     (19,951 )     19,686  

Cash and cash equivalents at beginning of year

     12,778       32,729       13,043  
    


 


 


Cash and cash equivalents at end of year

   $ 10,023     $ 12,778     $ 32,729  
    


 


 


Supplemental disclosure of cash flow information:

                        

Interest payments on convertible subordinated debt

   $ 5,573     $ 5,744     $  
    


 


 


Offset receivable from/due to Suncos Corporation

   $     $ 1,668     $  
    


 


 


Debt forgiven upon achievement of clinical milestones

   $     $     $ 5,294  
    


 


 


Note receivable from sale of partnership interests

   $     $     $ 6,000  
    


 


 


Issuance of restricted stock

   $ 18,040     $     $  
    


 


 


 

See accompanying notes to consolidated financial statements.

 

50


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(Dollars in thousands, except per share data)

 

(1) Summary of Significant Accounting Policies

 

(a) Nature of Operations

 

ICOS Corporation is a biotechnology company that is dedicated to bringing innovative therapeutic products to patients. We are marketing our first product, Cialis (tadalafil), for the treatment of erectile dysfunction through Lilly ICOS, our joint venture with Eli Lilly and Company (Lilly). Our goal is to develop and commercialize treatments for serious unmet medical conditions such as benign prostatic hyperplasia, hypertension, pulmonary arterial hypertension, cancer and inflammatory diseases.

 

(b) Principles of Consolidation

 

The consolidated financial statements include the accounts of ICOS Corporation and its subsidiaries (collectively, ICOS), all of which are wholly-owned. All significant intercompany transactions and balances have been eliminated in consolidation.

 

ICOS and Lilly each own 50% of Lilly ICOS and have joint authority to make decisions on its behalf. Accordingly, we account for our investment using the equity method, whereby our investment is recorded at cost adjusted for (i) our share of Lilly ICOS’ total comprehensive income or loss, and (ii) distributions from Lilly ICOS. Our share of Lilly ICOS’ net income or net loss is reported in our consolidated statements of operations as equity in income (losses) of affiliates, and our share of Lilly ICOS’ unrealized gains and losses, if any, are reported as a component of total comprehensive loss.

 

(c) Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses. Actual results could differ from those estimates.

 

(d) Cash and Cash Equivalents

 

All highly liquid short-term investments with a maturity at purchase of three months or less are considered to be cash equivalents and are carried at market value. Our cash equivalents consist primarily of money market accounts, commercial paper and short-term obligations of U.S. government agencies and sponsored enterprises.

 

(e) Investment Securities

 

Our investment securities consist primarily of fixed-rate corporate and taxable municipal bonds, corporate and taxable municipal auction and floating rate securities and obligations of U.S. government agencies and sponsored enterprises. Management considers all investment securities as available-for-sale. Accordingly, all investment securities are carried at market value, based on quoted market prices, with unrealized gains and losses excluded from results of operations and reported as a component of total comprehensive loss. Realized gains and losses on sales of investment securities are determined on the specific identification method and included in interest and other income. We do not have any derivative financial instruments in our investment portfolio.

 

51


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

(f) Property and Equipment

 

Property and equipment are stated at cost and depreciated using the straight line method. Significant additions and improvements to property and equipment are capitalized. Maintenance and repair costs are expensed as incurred. We own one building which is being depreciated over its estimated useful life of ten years. Leasehold improvements are amortized over the shorter of their estimated useful lives or the term of the lease. Building improvements are amortized over the shorter of their estimated useful lives or the estimated remaining economic life of the building. Depreciation on furniture and equipment is determined based on estimated useful lives of three to five years.

 

(g) Deferred Financing Costs

 

In connection with the issuance of our convertible subordinated notes, we incurred $8.7 million of debt issuance costs, which have been deferred and are being amortized, using the interest method, as interest expense, through July 1, 2010, the earliest date on which note holders may require us to repurchase the notes.

 

(h) Fair Value of Financial Instruments

 

Our financial instruments include cash, cash equivalents, marketable investment securities, receivables, accounts payable and convertible subordinated debt. Marketable investment securities are carried at fair value on our consolidated balance sheets based on quoted market prices. Our convertible subordinated debt is carried at cost on our consolidated balance sheets. The fair value of our convertible subordinated debt was $225.8 million at December 31, 2005, with a carrying amount of $278.7 million at that date. Fair value of the convertible subordinated debt was determined by obtaining quotes from a market maker for the notes. The carrying amounts reflected in the consolidated balance sheets for the remaining items approximate fair value due to their market rates of interest and/or their short-term maturities.

 

(i) Impairment of Long-Lived Assets

 

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are not expected to be sufficient to recover the carrying amount of the asset, the asset is written-down to its estimated fair value in accordance with Financial Accounting Standards Board Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

 

(j) Revenue Recognition

 

Collaboration revenue

 

We recognize revenue from our contracts for research, development, marketing and sales services, as the related billable time and costs are incurred. Payments received, related to future performance, are deferred and recognized as revenue when the future performance occurs.

 

Contract manufacturing

 

Contract manufacturing revenue, including fees earned for process development and manufacturing services performed for third parties, is recognized when collectibility is reasonably assured and the manufacturing

 

52


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

obligation is fulfilled or manufacturing services are performed, as appropriate, based on the terms of the agreement. Payments received in excess of amounts earned are recorded as deferred revenue.

 

Co-promotion services

 

Co-promotion services revenue represents fees earned for physician details (sales calls) and other activities related to our promotion of others’ products. We recognize this revenue, at contractual rates, as the specified co-promotion services are provided.

 

Licenses of technology

 

Nonrefundable upfront technology license fees, for product candidates where we are providing continuing services related to product development, are deferred, and recognized as revenue as we provide the services required under the agreement. We recognize nonrefundable upfront technology fees as revenue based on the ratio of current development costs to total estimated current and future development costs through the date we expect to file a New Drug Application (NDA), or an equivalent, with the FDA. We believe this method appropriately matches revenue with the estimated costs of the development effort. We also believe that development costs are the best available surrogate for benefits obtained as data is collected and other research and development activities progress related to the licensed technology.

 

We estimate the total projected development costs based on the specific terms of each agreement, our judgment and experience and, when appropriate, the expertise of our collaboration partners. The ability to estimate total development effort and costs can vary significantly for each product candidate due to the inherent complexities and uncertainties of drug development. In the past, we have been able to estimate total expected development costs, for certain product candidates, because they were in later stages of clinical development at the time such estimates were prepared or our partner had substantial previous experience in the relevant field of study. However, we may not be able to reasonably estimate total expected development costs for product candidates in the future, particularly if such product candidates are in earlier stages of clinical development. To the extent we cannot estimate the costs to complete development, but can estimate an expected NDA filing date, we will recognize license fee revenue ratably through the expected NDA filing date. If we are unable to reasonably estimate either total costs to complete development or an expected NDA filing date (performance period), we will defer revenue recognition until one of those estimates can be made or the project is discontinued.

 

Milestones, in the form of additional license fees, typically represent nonrefundable payments to be received in conjunction with the achievement of a specific event identified in the contract, such as initiation or completion of specified clinical development activities. We believe that a milestone represents the culmination of a distinct earnings process when it is not associated with ongoing research, development or other performance on our part. We recognize such milestones as revenue when they become due and collectibility is reasonably assured. When a milestone does not represent the culmination of a distinct earnings process, we recognize revenue at the time such payments are due, provided collectibility is reasonably assured, based on the ratio of effort to date (in terms of costs or time, as discussed above) to total estimated development effort. Any remaining balance is deferred and recognized as revenue over the estimated remaining product development period, in the same manner as our upfront technology license fees.

 

The timing and amount of revenue that we recognize from licenses of technology, either from upfront fees or milestones where we are providing continuing services related to product development, is dependent upon our estimates of total product development effort as well as the timing of such effort over the estimated development period. As product candidates move through the development process, it is necessary to revise these estimates to

 

53


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

consider changes to the product development cycle, such as changes in the clinical development plan, regulatory requirements, or various other factors, many of which may be outside of our control. The impact on revenue of changes in our estimates and the timing thereof, is recognized prospectively, over the remaining estimated product development period.

 

(k) Cost of Contract Manufacturing

 

Contract manufacturing expenses are principally comprised of costs for: personnel, including salaries and benefits; occupancy; raw materials and consumables used in process development and manufacturing; testing services provided by third parties; facility overhead, including taxes, depreciation, utilities and maintenance of manufacturing equipment; and other shared services, including information systems and staff support. Contract manufacturing costs generally are expensed when the related revenue is recognized.

 

(l) Research and Development Costs

 

Research and development expenses are principally comprised of costs for: personnel, including salaries and benefits; occupancy; clinical studies performed by third parties; materials and supplies to support our clinical programs; contract research; manufacturing; consulting arrangements; in-licensing fees; and other expenses incurred to operate our research and development programs. Research and development costs are expensed as incurred.

 

Some of our research and development, including certain clinical study activities, are conducted by third parties, including contract research organizations, which may also provide contractually defined administration and management services. We recognize expenses for these contracted activities based on a variety of factors, including actual and estimated labor hours, clinical site initiation activities, patient enrollment rates, estimates of external costs and other activity-based factors. On a regular basis, our estimates of these costs are reconciled to actual invoices from the service providers and adjustments are made accordingly.

 

(m) Income Taxes

 

Income taxes are accounted for using the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, loss carryforwards and tax credits. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established when necessary to reduce deferred tax assets to the amounts expected to be realized.

 

(n) Off-Balance Sheet Arrangements

 

In the ordinary course of business, we enter into agreements that require us to indemnify counterparties against third-party claims. These may include: agreements with vendors and suppliers, under which we may indemnify them against claims arising from our use of their products or services; agreements with customers, under which we may indemnify them against claims arising from their use of our products or services; real estate and equipment leases, under which we may indemnify lessors against third-party claims relating to use of their property; agreements with licensees or licensors, under which we may indemnify the licensee or licensor against claims arising from their use of our intellectual property or our use of their intellectual property; and agreements

 

54


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

with initial purchasers and underwriters of our securities, under which we may indemnify them against claims relating to their participation in the transactions.

 

The nature and terms of these indemnifications vary from contract to contract, and generally a maximum obligation is not stated. Because we are unable to estimate our potential obligation, and because management does not expect these indemnifications to have a material adverse effect on our consolidated financial position, results of operations or cash flows, no related liabilities are recorded at December 31, 2005. We hold insurance policies that mitigate potential losses arising from certain indemnifications and, historically, we have not incurred significant costs related to performance under these obligations.

 

(o) Basic and Diluted Net Income (Loss) Per Common Share

 

Basic net income (loss) per common share is calculated based on the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per common share is calculated based on the weighted-average number of common shares and other dilutive securities. Dilutive potential common shares resulting from the assumed exercise of outstanding stock options and vesting of restricted stock are determined using the treasury method. Dilutive potential common shares resulting from the assumed conversion of convertible subordinated debt are determined using the if-converted method.

 

(p) Operating Segments

 

We operate in one segment, the development and commercialization of pharmaceutical products for human therapeutic use.

 

(q) Stock Based Compensation

 

We apply the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB No. 25), and related interpretations in accounting for our stock based employee compensation. Accordingly, we do not recognize compensation expense for options granted to employees and non-employee directors with exercise prices equal to or in excess of the fair value of the underlying common shares at the date of grant. We recognize compensation expense for restricted stock grants on a straight line basis over the applicable vesting period.

 

Had we determined compensation expense based on fair value in accordance with Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation,” our net loss and net loss per common share would have been as follows:

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Net loss:

                        

As reported

   $ (74,842 )   $ (198,248 )   $ (125,507 )

Add: Stock based compensation expense included in reported net loss

     2,113       183       275  

Deduct: Stock based compensation expense determined under fair value based method for all awards

     (33,370 )     (36,731 )     (47,422 )
    


 


 


Pro forma

   $ (106,099 )   $ (234,796 )   $ (172,654 )
    


 


 


Net loss per common share — basic and diluted:

                        

As reported

   $ (1.17 )   $ (3.13 )   $ (2.01 )
    


 


 


Pro forma

   $ (1.66 )   $ (3.70 )   $ (2.76 )
    


 


 


 

55


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

The estimated per share weighted-average grant date fair value of stock options awarded during 2005, 2004 and 2003 was $12.08, $26.78, and $21.03, respectively. Amounts were determined using the Black-Scholes option pricing model based on the following assumptions:

 

     Year Ended December 31,

 
         2005    

        2004    

        2003    

 

Expected dividend yield

   0.0 %   0.0 %   0.0 %

Risk-free interest rate

   4.0 %   3.5 %   3.5 %

Expected volatility

   43.2 %   68.0 %   69.1 %

Expected life in years

   6.3     6.6     6.5  

 

We periodically update the volatility assumption used to estimate the fair value of stock options. The expected volatility used to value stock options granted in 2005 was determined considering historical volatility of our common stock over the preceding six years, implied volatility of near-the-money traded stock options with remaining contractual maturities of approximately two years and significant changes in our business that we believe have resulted in lower volatility, both implied and in the past two years.

 

(r) Reclassification

 

Certain amounts reported in prior years have been reclassified to conform to the 2005 presentation.

 

(2) 2006 Required Accounting Change

 

Prior to January 1, 2006, we accounted for our stock-based compensation according to the provisions of APB No. 25 and related interpretations and did not recognize compensation expense for options granted to employees and non-employee directors with exercise prices equal to or in excess of the fair value of the underlying shares at the date of grant.

 

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123 (Revised 2004) (FAS 123R), “Share Based Payment”. Effective January 1, 2006, FAS 123R requires us to measure the cost of employee services received in exchange for equity instruments, such as stock options or restricted stock, based on the grant-date fair-value of the awards. The associated cost must be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). FAS 123R also requires us to estimate forfeitures in calculating stock based compensation expense, rather than recognizing the impact of the forfeitures as they occur, which was previously permitted.

 

We will implement FAS 123R, on a prospective basis, beginning in the 2006 first quarter. Prior year amounts will not be restated, and we will not record a cumulative effect adjustment upon adoption of FAS 123R.

 

56


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

(3) Collaborations

 

The following tables summarize our collaboration revenue from related parties, licenses of technology, equity in income (losses) of affiliates and investment in affiliates during the periods presented.

 

     Year Ended December 31,

 
     2005

   2004

    2003

 

Collaboration revenue from related parties:

                       

Lilly ICOS

                       

Marketing and sales

   $ 26,874    $ 39,658     $ 14,921  

Research and development

     23,181      16,373       7,172  
    

  


 


       50,055      56,031       22,093  

Suncos

                2,450  

ICOS-TBC

                1,400  
    

  


 


     $ 50,055    $ 56,031     $ 25,943  
    

  


 


Licenses of technology:

                       

Lilly ICOS

   $    $     $ 15,031  

Biogen (non-affiliate)

                21,945  

Other (non-affiliates)

          2,200        
    

  


 


     $    $ 2,200     $ 36,976  
    

  


 


Equity in income (losses) of affiliates:

                       

Lilly ICOS

   $ 19,519    $ (130,396 )   $ (87,320 )

Suncos

                140  
    

  


 


     $ 19,519    $ (130,396 )   $ (87,180 )
    

  


 


Investments in affiliates, net of distributions:

                       

Lilly ICOS

   $ 30,125    $ 140,423     $ 83,732  

ICOS-TBC

                2,618  
    

  


 


     $ 30,125    $ 140,423     $ 86,350  
    

  


 


 

Lilly ICOS

 

In October 1998, ICOS and Lilly formed Lilly ICOS to develop and commercialize PDE5 inhibitors, including Cialis. In addition to amounts received and recognized prior to 2003, we received and recognized, as license of technology revenue, a $15.0 million payment in 2003, following the first commercial sale of Cialis in the United States. ICOS and Lilly jointly manage Lilly ICOS and provide it with services required for research, development and commercialization. Lilly is the sole manufacturer of Cialis, under contract with Lilly ICOS. Lilly ICOS is marketing Cialis in North America and Europe. Lilly has exclusive rights to market Cialis in the remainder of the world, and pays royalties to Lilly ICOS of 20% of net sales in those territories.

 

Upon formation of the joint venture, ICOS contributed an exclusive license to intellectual property relating to PDE5 inhibitors, including technology associated with Cialis. ICOS acquired the rights to the contributed technology under an agreement with a third party in association with a previous collaboration. Pursuant to the terms of the third party agreement, ICOS committed to pay the third party a royalty equal to 5% of the net sales of products developed utilizing the acquired technology. Lilly ICOS and Lilly have assumed primary responsibility for these royalty obligations.

 

57


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

Lilly ICOS is a variable interest entity that is not consolidated in our financial statements because we are not its primary beneficiary.

 

Summarized unaudited financial information for Lilly ICOS follows:

 

     December 31,

 
     2005

   2004

 

Financial position:

               

Total current assets

   $ 81,619    $ 42,750  

Total noncurrent assets

     13,176      15,121  
    

  


Total assets

   $ 94,795    $ 57,871  
    

  


Total liabilities — all current

   $ 11,388    $ 72,509  

Members’ equity (deficit)

     83,407      (14,638 )
    

  


Total liabilities and members’ equity (deficit)

   $ 94,795    $ 57,871  
    

  


 

     Year Ended December 31,

 
     2005

   2004

    2003

 

Operating results:

                       

Revenue

   $ 610,703    $ 447,862     $ 144,533  

Cost of sales

     47,264      36,066       12,543  

Selling, general and administrative expenses, related parties

     459,827      606,511       243,110  

Research and development expenses, related parties

     65,816      67,318       63,622  
    

  


 


Net income (loss)

   $ 37,796    $ (262,033 )   $ (174,742 )
    

  


 


ICOS Corporation’s share of net income (loss)

   $ 19,519    $ (130,396 )   $ (87,320 )
    

  


 


 

Cost of sales includes license fee amortization, of $1.2 million in 2005 and 2004, respectively, and $0.1 million in 2003, applicable only to Lilly’s interest in Lilly ICOS.

 

Biogen IDEC, Inc.

 

In July 2001, we entered into an agreement with Biogen IDEC, Inc. (Biogen), under which we and Biogen cross-licensed LFA-1 antagonist technology and patents, including those related to IC747 and other LFA-1 antagonists, and equally shared in costs of development activities for the collaboration. Under the terms of the agreement, we received loans from Biogen to help fund our share of the related development costs. In June 2003, we announced that the LFA-1 antagonist collaboration with Biogen would be concluded and that we would reacquire sole development rights to the program. At that time, we recognized, as revenue, $21.3 million of deferred upfront fees and forgiven loans received from Biogen under the collaboration arrangement.

 

Suncos

 

Suncos Corporation was a 50/50-owned corporation that was developing Pafase. In December 2002, the Pafase development program was discontinued after an interim analysis did not demonstrate clinical benefit in a Phase 3 study for severe sepsis. In April 2004, the court approved Suncos’ voluntary plan of reorganization, resulting in Suncos’ merger with and into a wholly-owned subsidiary of ICOS. In conjunction with the reorganization, Daiichi Pharma Co., Ltd., the other 50% owner of Suncos, received certain non-U.S. Pafase licensing rights and ICOS received a cash payment of $1.7 million.

 

58


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

ICOS-TBC

 

In January 2003, we announced that joint development of endothelin receptor antagonists, through ICOS-TBC, would not continue. In April 2003, Encysive (our 50/50 partner in ICOS-TBC) acquired all of our interests in ICOS-TBC for $10.0 million, with $4.0 million paid on the date of the agreement and $6.0 million paid in March 2004. Other income, in 2003, includes a gain of $10.0 million from this transaction.

 

(4) Investment Securities

 

The following table summarizes our investment securities at December 31, 2005 and 2004:

 

     Market
Value


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


   Amortized
Cost


December 31, 2005:

                           

Fixed-rate corporate and taxable municipal bonds

   $ 57,487    $ 1    $ 417    $ 57,903

Obligations of U.S. government agencies and sponsored enterprises

     49,331           361      49,692

Corporate and taxable municipal auction and floating rate securities

     44,700                44,700
    

  

  

  

     $ 151,518    $ 1    $ 778    $ 152,295
    

  

  

  

December 31, 2004:

                           

Fixed-rate corporate and taxable municipal bonds

   $ 75,125    $ 65    $ 326    $ 75,386

Obligations of U.S. government agencies and sponsored enterprises

     57,909      1      436      58,344

Corporate and taxable municipal auction and floating rate securities

     128,350           2      128,352
    

  

  

  

     $ 261,384    $ 66    $ 764    $ 262,082
    

  

  

  

 

At December 31, 2005, gross unrealized losses on our investment securities relate to certain fixed-rate corporate and taxable municipal bonds, with an aggregate market value of $55.5 million, and obligations of U.S. government agencies and sponsored enterprises, with an aggregate market value of $49.3 million. Because we intend to hold these investments to maturity, we do not consider these investments to be other-than-temporarily impaired.

 

Market value and amortized cost of investment securities at December 31, 2005, by contractual maturity, are shown below.

 

Maturing:


   Market
Value


   Amortized
Cost


Less than 1 year

   $ 69,323    $ 69,704

1 to 2 years

     27,835      28,101

2 to 4 years

     11,660      11,790

Beyond 10 years

     42,700      42,700
    

  

     $ 151,518    $ 152,295
    

  

 

59


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

Actual maturities may be different from the contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

All investment securities listed as maturing beyond ten years have auction or floating interest rates that are reset, at least every 28 days, to minimize interest rate risk. These securities are classified as current in our consolidated balance sheets because they represent investments that are available to fund current operations.

 

(5) Property and Equipment, Net

 

     December 31,

 
     2005

    2004

 

Land

   $ 2,310     $ 2,310  

Building and improvements

     10,460       10,186  

Leasehold improvements

     16,860       15,842  

Furniture and equipment

     47,108       43,609  
    


 


Total cost

     76,738       71,947  

Less accumulated depreciation and amortization

     (58,743 )     (52,741 )
    


 


     $ 17,995     $ 19,206  
    


 


 

(6) Convertible Subordinated Debt

 

In mid-2003, we completed a private offering of $278.7 million of convertible subordinated notes, which accrue interest at 2% per annum, payable semiannually each January and July 1. The notes are unsecured, subordinated to any senior indebtedness, and convertible, at the option of the holder, into our common stock at a conversion price of $61.50 per share, subject to adjustment in certain circumstances. The notes mature on July 1, 2023. Note holders may require us to purchase, for cash, all or a portion of their notes on July 1, 2010, 2013 or 2018, at a price equal to the principal amount of the notes being repurchased. We may redeem all or a portion of the notes, at par, for cash at any time on or after July 5, 2010.

 

(7) Leases

 

We lease certain property and equipment under noncancelable operating leases which, in the aggregate, obligate us through 2012. Many of our leases contain renewal options and provide for escalations of rent and payment of real estate taxes, maintenance, insurance and certain other operating expenses of the properties.

 

Total rent expense was $6.7 million, $6.2 million and $6.1 million in 2005, 2004 and 2003, respectively.

 

Future minimum payments due under noncancelable operating leases are as follows:

 

2006

   $ 6,982

2007

     6,180

2008

     4,675

2009

     1,113

2010

     602

After 2010

     463
    

     $ 20,015
    

 

60


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

(8) Federal Income Taxes

 

Income taxes differ from the amount computed by applying the U.S. federal income tax rate to pre-tax income (loss) as a result of the following:

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Estimated federal income tax benefit

   $ (26,195 )   $ (69,387 )   $ (43,927 )

Research and experimentation tax credits

     (1,863 )     (2,653 )     (3,172 )

State income tax benefit, net of federal effect

     (748 )            

Other

     933       845       71  

Change in valuation allowance

     27,873       71,195       46,416  
    


 


 


     $     $     $ (612 )
    


 


 


 

The change in valuation allowance shown above excludes, in each year, the tax benefit of deductions generated by certain stock option exercises. If realized, those tax benefits will be credited directly to stockholders’ equity.

 

Deferred tax assets arising from temporary differences and carryforwards are as follows:

 

     December 31,

 
     2005

    2004

 

Depreciation

   $ 5,442     $ 5,037  

Net operating loss carryforwards

     331,112       278,154  

Research and experimentation tax credit carryforwards

     23,040       21,084  

Other

     4,746       3,511  
    


 


Gross deferred tax assets

     364,340       307,786  

Less valuation allowance

     (346,307 )     (307,786 )
    


 


       18,033        

Deferred tax liabilities

     (18,033 )      
    


 


Net deferred tax assets

   $     $  
    


 


 

The $38.5 million increase in the deferred tax asset valuation allowance, in 2005, was primarily due to net operating loss carryforwards and an increase in our estimated combined federal and state effective tax rate, from 35% to 36%.

 

At December 31, 2005, we have net operating loss carryforwards available to offset future taxable income as follows:

 

Year of Expiration


    

2009

   $ 5,060

2010

     21,507

2011

     21,039

2012

     26,774

2013

     7,687

2018

     359

2019

     36,827

2020

     71,231

2021

     92,850

2022

     130,399

2023

     166,581

2024

     213,456

2025

     125,986
    

     $ 919,756
    

 

61


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

Approximately $116.4 million of the net operating loss carryforwards as of December 31, 2005, result from stock option deductions, the realization of which would result in a credit to stockholders’ equity.

 

In addition to the net operating loss carryforwards indicated above, ICOS may have available to it approximately $159.1 million of net operating loss carryforwards acquired in conjunction with the April 2004 reorganization of Suncos.

 

Under provisions of the Internal Revenue Code of 1986, as amended, utilization of our net operating loss carryforwards may be subject to limitation if a greater than 50% ownership change has occurred or occurs in the future.

 

At December 31, 2005, we also had available approximately $23.0 million of research and experimentation tax credit carryforwards to offset future tax liabilities. These credits expire from 2009 to 2025.

 

(9) Preferred Stock

 

We have the authority to issue up to 2.0 million shares of preferred stock in one or more series, but have not issued any to date. Our Board of Directors has the authority to fix the powers, designations, preferences, and relative participating, optional, or other rights thereof, including dividend rights, conversion rights, voting rights, redemption terms, liquidation preferences, and the number of shares constituting any series, without any further vote or action by our stockholders. The issuance of preferred stock in certain circumstances may have the effect of delaying or preventing a change in control of ICOS. Such issuance, with voting and conversion rights, may adversely affect the voting power of the common stock holders. In the future, we may issue preferred stock as part of our overall financing strategy or pursuant to our Stockholder Rights Plan as described below.

 

Stockholder Rights Plan

 

In 2002, our Board of Directors adopted our Stockholder Rights Plan (Rights Plan) and declared a dividend distribution of one preferred share purchase right (Right) for (i) each then outstanding share of our common stock and (ii) shares of our common stock that become outstanding on or before the distribution date, as defined below. Each Right entitles its registered holder, under certain circumstances and upon the occurrence of certain events, to purchase from us one one-hundredth of a share of our Series A Junior Participating Preferred Stock, at a price of $250.00 per one one-hundredth of a preferred share, subject to adjustment. The Rights are not exercisable until the distribution date, a date that occurs after a person or group becomes an Acquiring Person, as described below, or commences or announces a tender or exchange offer that could result in the offeror becoming an Acquiring Person. Until the distribution date, or earlier redemption or expiration of the Rights, the Rights may only be transferred with the shares of our common stock.

 

If a person or group (collectively, an Acquiring Person) acquires beneficial ownership of 15% or more of our outstanding shares of common stock, then each Right (other than those held by an Acquiring Person, an affiliate, or an associate of that person) will entitle the holder to purchase, for the purchase price, the number of shares of common stock which at the time of the transaction would have a market value of twice the purchase price. Any Rights owned by an Acquiring Person, an affiliate, or an associate of that person, will be void and non-transferable. The Board of Directors may also elect to exchange each Right, other than those which become void and non-transferable as described above, for shares of common stock, without payment of the purchase price. Should the Board of Directors make this election, the exchange rate would be one-half of the number of shares of common stock that would otherwise be issuable at that time upon the exercise of one Right.

 

62


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

(10) Employee Benefit Plans

 

Defined Contribution 401(k) Benefit Plan

 

We sponsor the ICOS 401(k) Plan (the “401(k) Plan”) to help eligible full-time employees save for retirement. The 401(k) Plan, a qualified retirement plan under the Internal Revenue Code, allows participants to contribute up to the maximum amount permitted under IRS regulations. In addition, the 401(k) Plan provides for discretionary employer matching contributions, based on a percentage of a participant’s pretax contributions. Employer matching contributions generally vest at a rate of 25% per full year of employee service from the date of employment. During 2005, the ICOS matching contributions totaled $1.5 million. Prior to 2005, there were no ICOS matching contributions. All employee contributions are fully vested.

 

Stock Compensation Plan

 

In May 2005, our shareholders approved an amended and restated ICOS Corporation 1999 Long-Term Incentive Plan (Restated Plan). Among other changes, the Restated Plan, (i) permits the award of stock, stock units and/or stock appreciation rights (in addition to stock options); (ii) revises individual and aggregate share grant limits; and (iii) extends the term of the Restated Plan until January 27, 2015. A total of 15.4 million shares of common stock have been made available for grant (to our employees, directors and consultants) under the Restated Plan and its predecessors since adoption, including an increase of 2.9 million shares approved by shareholders in May 2005. At December 31, 2005, 2.9 million shares were reserved and remain available for grant under the Restated Plan.

 

In July 2005, pursuant to the Restated Plan, the Compensation Committee of our Board of Directors approved the grant of restricted stock retention awards, for an aggregate of approximately 0.8 million shares of ICOS common stock, to executive officers and certain non-officer employees. The awards had a weighted average grant date fair value of $22.03, and an aggregate fair market value on the grant date of approximately $18.0 million. Each award vests in its entirety at the end of a period of continued service, generally 3 to 5 years, or could vest earlier, in the event of qualifying terminations after a change in control of ICOS. In addition, ICOS’ Chairman, President and Chief Executive Officer has an employment agreement with ICOS that provides for full vesting of restricted stock awards upon termination of his employment under certain circumstances. During the year ended December 31, 2005, we recorded $2.1 million in compensation expense associated with these awards. All of the 0.8 million nonvested (restricted) stock awards were still outstanding at December 31, 2005.

 

All stock options are granted with an exercise price not less than 100% of the fair market value of the common stock on the grant date. The options generally vest ratably over a four-year period commencing on the grant date and have a term of ten years from the grant date.

 

63


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

A summary of stock option activity is as follows:

 

     Stock Options Outstanding

    

Number of

Shares


   

Weighted-

Average

Exercise

Price Per

Share


     (In thousands)      

Balance at December 31, 2002

   10,983     $ 30.15

Options granted

   690       31.84

Cancellations

   (251 )     40.29

Options exercised

   (908 )     9.58
    

 

Balance at December 31, 2003

   10,514       31.78

Options granted

   1,270       40.42

Cancellations

   (452 )     37.37

Options exercised

   (620 )     11.20
    

 

Balance at December 31, 2004

   10,712       33.76

Options granted

   1,636       24.99

Cancellations

   (813 )     36.60

Options exercised

   (594 )     11.58
    

 

Balance at December 31, 2005

   10,941     $ 33.45
    

 

 

The following table summarizes information about stock options outstanding and exercisable at December 31, 2005:

 

     Stock Options Outstanding

   Stock Options Exercisable

Range of

Exercise Prices


  

Number

(In thousands)


  

Weighted-Average

Remaining

Contractual Life

(In years)


  

Weighted-Average

Exercise Price Per

Share


  

Number

(In thousands)


  

Weighted-Average

Exercise Price Per

Share


$  6.63 – $19.75    1,216    1.6    $ 12.36    1,206    $ 12.31
20.63 –   29.73    3,406    7.4      26.07    1,935      26.64
29.74 –   39.06    1,848    6.3      31.12    1,435      30.97
39.11 –   42.88    2,634    5.2      42.51    2,189      42.59
42.93 –   66.53    1,837    5.8      50.44    1,763      50.69

  
  
  

  
  

$  6.63 – $66.53    10,941    5.8    $ 33.45    8,528    $ 34.45

  
  
  

  
  

 

Change in Control Severance Plan

 

In July 2005, our Board of Directors adopted the ICOS Corporation Change in Control Severance Plan (Severance Plan), which is intended to provide for retention of our employees in the event that a change in control of ICOS (as defined in the Severance Plan) occurred. All ICOS employees are eligible to participate in the Severance Plan. The Severance Plan may provide certain cash and health-related benefits to executive officers and other eligible employees in the event that, within a certain period after the change of control of ICOS, the individual’s employment is terminated.

 

64


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

(11) Computation of Net Loss Per Common Share

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Numerator:

                        

Net loss

   $ (74,842 )   $ (198,248 )   $ (125,507 )

Denominator:

                        

Weighted-average common shares (in thousands)

     63,996       63,435       62,561  
    


 


 


Net loss per common share — basic and diluted

   $ (1.17 )   $ (3.13 )   $ (2.01 )
    


 


 


 

Antidilutive securities excluded from the computation of diluted net loss per common share were as follows:

 

    

Year Ended December 31,

(In thousands)


     2005

   2004

   2003

Nonvested (restricted) stock

   818      

Shares issuable upon:

              

Exercise of stock options

   10,941    10,712    10,514

Exercise of stock warrants

         7,429

Conversion of subordinated debt

   4,531    4,531    4,531

 

(12) Legal Proceedings

 

In October 2002, Pfizer Inc., Pfizer Limited, and Pfizer Ireland Pharmaceuticals filed a patent infringement lawsuit against ICOS, Lilly ICOS and Lilly in the United States District Court for the District of Delaware. Pfizer contends that the use, offering for sale, selling, manufacture or importing of Cialis, into the United States, for the treatment of erectile dysfunction by any of the defendants infringes claim 24 of Pfizer’s U.S. Patent No. 6,469,012 (or the Pfizer Patent), and seeks a declaratory judgment to that effect. Pfizer also seeks a permanent injunction, attorneys’ fees, costs and expenses. In January 2003, we and the other defendants filed an answer denying the central allegations of plaintiffs’ complaint and setting forth various affirmative defenses.

 

The U.S. Patent and Trademark Office (PTO) subsequently ordered the reexamination of the Pfizer Patent. Under the reexamination process, the PTO is required to reconsider the validity of the patent if substantial new questions of patentability are raised by any party including the PTO itself. The District Court stayed, or suspended, the patent infringement lawsuit, pending the outcome of the reexamination. Subsequently, Lilly ICOS and other parties filed several reexamination requests regarding the Pfizer Patent, which were merged with the PTO’s ordered reexamination. The first office action issued by the PTO rejected claim 24 of the Pfizer Patent. The Examiner rejected claim 24 on the basis that certain prior art rendered the claimed invention not new and therefore unpatentable under 35 U.S.C. §102(b), and obvious under the judicially created doctrine of obviousness-type double patenting. The Examiner did not accept any of the other arguments made in the then-pending petitions for reexamination. We later filed a new request for reexamination of claim 24, which was granted by the PTO. Lilly also filed a separate new request for reexamination of claim 24; however, this request was denied. On September 15, 2005, the PTO issued a second office action that rejected Pfizer’s arguments made in response to the first office action, reaffirmed the initial rejection of claim 24, and entered new grounds for rejecting claim 24. The September 15, 2005 office action also maintained the obviousness-type double patenting rejection of the other claims. On November 15, 2005, Pfizer filed its response to the September 15, 2005 office action. According to PTO procedure, the PTO should issue a further action, which may finalize the rejections of

 

65


Table of Contents

ICOS CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

(Dollars in thousands, except per share data)

 

claim 24, withdraw the rejections of that claim, or allow an amended claim to be entered. Pfizer can challenge the result of a final office action within the PTO and subsequently in court.

 

Litigation is inherently unpredictable and the eventual outcome in a particular case is impossible to determine in advance. We believe that Pfizer’s suit lacks merit and intend to vigorously pursue our various defenses. If Pfizer were to prevail in its suit against us, however, we might be subject to substantial damages, prohibited from marketing Cialis for the treatment of erectile dysfunction in the United States, or required by Pfizer to enter into a licensing agreement to market Cialis in the United States. Any such adverse result could have a material adverse effect on our business, financial position, results of operations and cash flows.

 

On July 20, 2005, a lawsuit was filed against ICOS by Vanderbilt University in the United States District Court for the District of Delaware. Vanderbilt filed the lawsuit asserting that three of its researchers contributed to the conception of the inventions reflected in U.S. Patent Nos. 5,859,006 and 6,140,329. U.S. Patent No. 5,859,006 is ICOS’ patent claiming tadalafil and certain related compounds; U.S. Patent No. 6,140,329 is ICOS’ patent claiming the use of tadalafil and certain related compounds to treat erectile dysfunction. Tadalafil is the active ingredient in Cialis, which is marketed in North America by Lilly ICOS, which has an exclusive license to U.S. Patent Nos. 5,859,006 and 6,140,329. The Vanderbilt lawsuit requests that the Court direct the U.S. Commissioner of Patents and Trademarks to add the three individual researchers as co-inventors on these patents. ICOS timely filed a response to the complaint on September 9, 2005, denying the central allegations of Vanderbilt’s complaint and setting forth various affirmative defenses. While the Company is diligently evaluating Vanderbilt’s claims and seeking additional information, it currently believes that Vanderbilt’s claims lack merit and intends to defend the lawsuit vigorously. Because the suit is in its early stages, it is premature to assess what, if any, impact the lawsuit might have on our business, financial position, results of operations and cash flows.

 

(13) Quarterly Financial Data (Unaudited)

 

Summary operating data for each quarter of the years ended December 31, 2005 and 2004 follows:

 

     Quarters

    Total

 
     First

    Second

    Third

    Fourth

   

2005:

                                        

Revenue

   $ 13,784     $ 18,088     $ 20,766     $ 18,772     $ 71,410  

Net income (loss)

   $ (46,384 )   $ (22,625 )   $ (11,454 )   $ 5,621     $ (74,842 )

Net income (loss) per common
share — basic

   $ (0.73 )   $ (0.35 )   $ (0.18 )   $ 0.09     $ (1.17 )

Net income (loss) per common
share — diluted

   $ (0.73 )   $ (0.35 )   $ (0.18 )   $ 0.09     $ (1.17 )

2004:

                                        

Revenue

   $ 16,523     $ 17,926     $ 19,744     $ 20,415     $ 74,608  

Net income (loss)

   $ (86,303 )   $ (51,898 )   $ (26,600 )   $ (33,447 )   $ (198,248 )

Net income (loss) per common
share — basic

   $ (1.36 )   $ (0.82 )   $ (0.42 )   $ (0.53 )   $ (3.13 )

Net income (loss) per common
share — diluted

   $ (1.36 )   $ (0.82 )   $ (0.42 )   $ (0.53 )   $ (3.13 )

 

66


Table of Contents
Item 9A.   Controls and Procedures

 

(a) Evaluation of disclosure controls and procedures.    Our chief executive officer and our chief financial officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this annual report, have concluded that, as of that date, our disclosure controls and procedures were effective.

 

(b) Management’s report on internal control over financial reporting.    Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting. That evaluation was conducted based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2005. Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.

 

(c) Changes in internal control over financial reporting.    There were no significant changes in our internal control over financial reporting during the fourth quarter of 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

67


Table of Contents

PART III

 

Item 10.   Directors and Executive Officers of the Registrant

 

The information required by this item is incorporated by reference from the sections entitled “Security Ownership of Principal Shareholders and Management,” “Proposal 1: Election of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in ICOS’ Proxy Statement for the Annual Meeting of Stockholders to be held on May 11, 2006.

 

Code of Ethics

 

We have adopted our Code of Conduct, which applies to all employees and directors of ICOS. Our Code of Conduct meets the requirements of a “code of ethics” as defined by Item 406 of Regulation S-K, and applies to our Chief Executive Officer and Chief Financial Officer (who is both our principal financial and principal accounting officer), as well as all other employees, as indicated above. Our Code of Conduct also meets the requirements of a code of conduct under Marketplace Rule 4350(n) of the National Association of Securities Dealers. Our Code of Conduct is available on our website at www.icos.com. We intend to satisfy the disclosure requirement under Item 10 of Form 10-K, regarding an amendment to, or waiver from, a provision of our Code of Conduct with respect to directors and executive officers, by posting such information on our website.

 

Item 11.   Executive Compensation

 

The information required by this item is incorporated by reference from the sections entitled “Proposal 1: Election of Directors,” “Executive Compensation,” “Report of the Compensation Committee on Executive Compensation,” “Stock Price Performance Graph” and “Employment Contracts, Termination of Employment and Change in Control Arrangements” in ICOS’ Proxy Statement for the Annual Meeting of Stockholders to be held on May 11, 2006.

 

Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

The following table sets forth information, as of December 31, 2005, with respect to our compensation plans, for which our common stock is authorized for issuance. All of our compensation plans have been approved by security holders (see Note 10 in the Notes to Consolidated Financial Statements for a description of our stock compensation plan).

 

     Number of
Securities to be
Issued Upon
Exercise of
Outstanding
Stock Options


   Weighted-
Average
Exercise Price
per Share of
Outstanding
Stock Options


   Number of Securities
Remaining Available
for Future Issuance
Under Equity
Compensation Plans


Equity compensation plans approved by security holders

   10,940,606    $ 33.45    2,867,756

 

The other information required by this item is incorporated by reference from the section entitled “Security Ownership of Principal Shareholders and Management” in ICOS’ Proxy Statement for the Annual Meeting of Stockholders to be held on May 11, 2006.

 

Item 14.   Principal Accounting Fees and Services

 

The information required by this item is incorporated by reference from the section entitled “Proposal 2: Ratification of the Appointment of the Independent Registered Public Accounting Firm” in ICOS’ Proxy Statement for the Annual Meeting of Stockholders to be held on May 11, 2006.

 

68


Table of Contents

PART IV

 

Item 15.   Exhibits, Consolidated Financial Statement Schedules

 

  (a)    1. Consolidated Financial Statements

 

See Index to Consolidated Financial Statements under Item 8 of this Form 10-K.

 

           2. Consolidated Financial Statement Schedules

 

Balance sheets of Lilly ICOS LLC as of December 31, 2005 and 2004, and related statements of operations, members’ equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2005, together with the report of Lilly ICOS’ independent registered public accounting firm.

 

All other consolidated financial statement schedules have been omitted as the information is not required or the information required is included in the consolidated financial statements or notes thereto.

 

           3. Exhibits

 

See Index to Exhibits filed herewith.

 

69


Table of Contents

LILLY ICOS LLC

 

TABLE OF CONTENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   71

Balance Sheets as of December 31, 2005 and 2004

   72

Statements of Operations for the Years Ended December 31, 2005, 2004 and 2003

   73

Statements of Members’ Equity (Deficit) for the Years Ended December 31, 2005, 2004 and 2003

   74

Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003

   75

Notes to Financial Statements

   76

 

70


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Managers

Lilly ICOS LLC:

 

We have audited the accompanying balance sheets of Lilly ICOS LLC as of December 31, 2005 and 2004, and the related statements of operations, members’ equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2005. 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 the standards of the Public Company Accounting Oversight Board (United States). 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 financial position of Lilly ICOS LLC as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

 

/s/ KPMG LLP

 

Seattle, Washington

March 1, 2006

 

71


Table of Contents

LILLY ICOS LLC

 

BALANCE SHEETS

 

(In thousands)

 

     December 31,

 
     2005

   2004

 
ASSETS                

Current assets:

               

Cash and cash equivalents

   $ 13,135    $ 97  

Accounts receivable, trade

     62,850      37,883  

Receivable from Eli Lilly and Company

     13,043       

Prepaid expenses

     5,634      4,770  
    

  


Total current assets

     94,662      42,750  

Property and equipment, net

     762      1,466  

License fee, net

     12,414      13,655  
    

  


     $ 107,838    $ 57,871  
    

  


LIABILITIES AND MEMBERS’ EQUITY (DEFICIT)                

Current liabilities:

               

Accrued liabilities

   $ 5,221    $ 7,178  

Accrued sales returns and allowances

     4,629      4,315  

Payables to members

     14,581      61,016  
    

  


Total current liabilities

     24,431      72,509  
    

  


Members’ equity (deficit):

               

Eli Lilly and Company

     47,910      (491 )

ICOS Corporation

     35,497      (14,147 )
    

  


Total members’ equity (deficit)

     83,407      (14,638 )
    

  


     $ 107,838    $ 57,871  
    

  


 

See accompanying notes to financial statements.

 

72


Table of Contents

LILLY ICOS LLC

 

STATEMENTS OF OPERATIONS

 

(In thousands)

 

     Year Ended December 31,

 
     2005

   2004

    2003

 

Revenue:

                       

Product sales, net

   $ 576,734    $ 421,742     $ 129,828  

Royalties, related party

     33,969      26,120       14,705  
    

  


 


Total revenue

     610,703      447,862       144,533  
    

  


 


Expenses:

                       

Cost of sales

     47,264      36,066       12,543  

Selling, general and administrative

                       

Eli Lilly and Company

     425,908      559,493       229,130  

ICOS Corporation

     33,919      47,018       13,980  

Research and development

                       

Eli Lilly and Company

     41,769      50,977       55,509  

ICOS Corporation

     24,047      16,341       8,113  
    

  


 


Total expenses

     572,907      709,895       319,275  
    

  


 


Net income (loss)

   $ 37,796    $ (262,033 )   $ (174,742 )
    

  


 


 

See accompanying notes to financial statements.

 

73


Table of Contents

LILLY ICOS LLC

 

STATEMENTS OF MEMBERS’ EQUITY (DEFICIT)

 

(In thousands)

 

     Eli Lilly
and
Company


    ICOS
Corporation


    Total
Members’ Equity
(Deficit)


 

Balances at December 31, 2002

   $ (20,587 )   $ (20,587 )   $ (41,174 )

Net loss

     (87,423 )     (87,319 )     (174,742 )

Member cash contributions

     98,733       83,732       182,465  

Member technology license contribution

           15,000       15,000  

Capital distribution

           (15,000 )     (15,000 )
    


 


 


Balances at December 31, 2003

     (9,277 )     (24,174 )     (33,451 )

Net loss

     (131,637 )     (130,396 )     (262,033 )

Member cash contributions

     140,423       140,423       280,846  
    


 


 


Balances at December 31, 2004

     (491 )     (14,147 )     (14,638 )

Net income

     18,277       19,519       37,796  

Member cash contributions

     36,763       36,764       73,527  

Distribution to members

     (6,639 )     (6,639 )     (13,278 )
    


 


 


Balances at December 31, 2005

   $ 47,910     $ 35,497     $ 83,407  
    


 


 


 

See accompanying notes to financial statements.

 

74


Table of Contents

LILLY ICOS LLC

 

STATEMENTS OF CASH FLOWS

 

(In thousands)

 

     Year Ended December 31,

 
     2005

    2004

    2003

 

Cash flows from operating activities:

                        

Net income (loss)

   $ 37,796     $ (262,033 )   $ (174,742 )

Adjustments to reconcile net income (loss) to net cash used in operating activities:

                        

Depreciation and amortization

     1,945       1,916       452  

Changes in operating assets and liabilities:

                        

Accounts receivable, trade

     (24,967 )     10,027       (47,910 )

Receivable from Eli Lilly and Company

     (13,043 )            

Prepaid expenses

     (864 )     10,570       (6,006 )

Accrued liabilities

     (1,957 )     (1,730 )     (3,952 )

Accrued sales returns and allowances

     314       (2,499 )     6,814  

Payables to members

     (46,435 )     (36,679 )     58,633  
    


 


 


Net cash used in operating activities

     (47,211 )     (280,428 )     (166,711 )
    


 


 


Cash flows from investing activities:

                        

Acquisitions of property and equipment

           (364 )     (712 )
    


 


 


Net cash used in investing activities

           (364 )     (712 )
    


 


 


Cash flows from financing activities:

                        

Member contributions

     73,527       280,846       182,465  

Distributions to members

     (13,278 )           (15,000 )
    


 


 


Net cash provided by financing activities

     60,249       280,846       167,465  
    


 


 


Net increase in cash and cash equivalents

     13,038       54       42  

Cash and cash equivalents at beginning of period

     97       43       1  
    


 


 


Cash and cash equivalents at end of period

   $ 13,135     $ 97<