Edgar Filing: ZYMOGENETICS INC

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(MARK ONE)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

Commission File Number: 0-33489

ZYMOGENETICS, INC.

(exact name of registrant as specified in its charter)

Washington

91-1144498

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer Identification No.)

1201 Eastlake Avenue East, Seattle, Washington 98102

(Address of principal executive offices) (Zip Code)

(206) 442-6600

(Registrant’s telephone number, including area code)

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common stock outstanding at July 22, 2005: 58,012,804 shares.

ZYMOGENETICS, INC.

Quarterly Report on Form 10-Q

For the quarterly period ended June 30, 2005

TABLE OF CONTENTS


		Page No.

PART I	FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)
a)	Balance Sheets	3
b)	Statements of Operations	4
c)	Statements of Cash Flows	5
d)	Notes to Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	17

Item 4.	Controls and Procedures	17

PART II	OTHER INFORMATION

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	18

Item 4.	Submission of Matters to a Vote of Security Holders	18

Item 6.	Exhibits	18

SIGNATURE		19

PART I

FINANCIAL INFORMATION

Item 1.

Financial Statements

ZYMOGENETICS, INC.

BALANCE SHEETS

(in thousands)

(unaudited)


	June 30, 2005			December 31, 2004
Assets
Current assets
Cash and cash equivalents	$	53,737		$	117,308
Short-term investments		221,353			207,690
Receivables
Related party		1,312			2,612
Trade		2,330			2,213
Interest and other receivables		1,088			1,453
Prepaid expenses		3,222			3,234

Total current assets		283,042			334,510
Property and equipment, net		71,508			71,960
Other assets		6,064			5,714

Total assets	$	360,614		$	412,184

Liabilities and Shareholders’ Equity
Current liabilities
Accounts payable	$	3,919		$	3,867
Accrued liabilities		9,796			11,104
Deferred revenue		16,668			22,178

Total current liabilities		30,383			37,149
Lease obligations		66,365			66,085
Deferred revenue		19,903			26,485
Other noncurrent liabilities		3,817			3,915
Commitments and contingencies
Shareholders’ equity
Common stock, no par value, 150,000 shares authorized, 57,926 and 57,574 issued and outstanding at June 30, 2005 and December 31, 2004, respectively		574,201			572,564
Non-voting common stock, no par value, 30,000 shares authorized		—			—
Deferred stock compensation		(758	)		(2,966	)
Accumulated deficit		(332,380	)		(289,789	)
Accumulated other comprehensive loss		(917	)		(1,259	)

Total shareholders’ equity		240,146			278,550

Total liabilities and shareholders’ equity	$	360,614		$	412,184

The accompanying notes are an integral part of these financial statements.

ZYMOGENETICS, INC.

STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Revenues
Royalties
Related party	$	874		$	1,594		$	2,397		$	3,187
Other		963			770			1,821			1,587
Option fee
Related party		1,875			1,875			3,750			3,750
Other		784			—			1,569			—
License fees and milestone payments
Related party		2,270			1,200			5,538			2,401
Other		1,249			2,914			4,895			3,117

Total revenues		8,015			8,353			19,970			14,042

Operating expenses
Research and development (includes noncash stock-based compensation expense of $812, $1,627, $1,748 and $2,645, respectively)		25,888			24,473			50,419			44,554
General and administrative (includes noncash stock-based compensation expense of $142, $3,133, $452 and $3,687, respectively)		5,861			7,593			11,845			12,082

Total operating expenses		31,749			32,066			62,264			56,636

Loss from operations		(23,734	)		(23,713	)		(42,294	)		(42,594	)
Other income (expense)
Investment income		1,831			948			3,449			2,350
Interest expense		(1,895	)		(1,674	)		(3,773	)		(3,096	)
Other, net		(5	)		(27	)		27			(23	)

Total other expense		(69	)		(753	)		(297	)		(769	)

Net loss	$	(23,803	)	$	(24,466	)	$	(42,591	)	$	(43,363	)

Basic and diluted net loss per share	$	(0.41	)	$	(0.46	)	$	(0.74	)	$	(0.82	)

Weighted-average number of shares used in computing net loss per share		57,855			53,207			57,764			52,954

The accompanying notes are an integral part of these financial statements.

ZYMOGENETICS, INC.

STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Six Months Ended June 30,
	2005			2004
Operating activities
Net loss	$	(42,591	)	$	(43,363	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization		3,134			2,568
Net gain on disposition of property and equipment		(29	)		(1	)
Noncash milestone revenue		(500	)		—
Noncash stock-based compensation		2,200			6,332
Net realized loss (gain) on short-term investments		380			(5	)
Amortization of premium on short-term investments		778			1,489
Changes in operating assets and liabilities
Receivables		1,548			(140	)
Prepaid expenses and other assets		161			(1,680	)
Accounts payable		464			(150	)
Accrued liabilities		(1,308	)		877
Deferred revenue		(12,092	)		(256	)
Deferred lease obligations		280			30
Other noncurrent liabilities		(97	)		467

Net cash used in operating activities		(47,672	)		(33,832	)

Investing activities
Purchases of property and equipment		(3,065	)		(10,295	)
Purchases of short-term investments		(163,082	)		(177,508	)
Proceeds from sale of property and equipment		—			5
Proceeds from sale and maturity of short-term investments		148,603			172,335

Net cash used in investing activities		(17,544	)		(15,463	)

Financing activities
Net proceeds from issuance of common stock		—			10,266
Construction advance from landlord		—			6,943
Proceeds from exercise of stock options		1,645			2,039

Net cash provided by financing activities		1,645			19,248

Net decrease in cash and cash equivalents		(63,571	)		(30,047	)
Cash and cash equivalents at beginning of period		117,308			97,576


Cash and cash equivalents at end of period	$	53,737		$	67,529

Supplemental disclosures
Cash paid for interest	$	3,773		$	3,097

Noncash financing activities:
Other non-cash additions (reductions) to property and equipment	$	412		$	(1,028	)

Non-cash settlement of notes receivable	$	—		$	725

Non-cash settlement of interest receivable	$	—		$	22

The accompanying notes are an integral part of these financial statements.

ZYMOGENETICS, INC.

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1.	Basis of presentation

The accompanying unaudited financial statements of ZymoGenetics, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of management, the financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position and results of operations as of and for the periods indicated. Operating results for such periods are not necessarily indicative of the results that may be expected for the full year or for any future period.

The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements should be read in conjunction with the audited financial statements and related footnotes included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2004.

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

2.	Net loss per share

Basic and diluted net loss per share has been computed based on net loss and the weighted-average number of common shares outstanding during the applicable period. The Company has excluded all outstanding options to purchase common stock as such shares are antidilutive for all periods presented.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Net loss	$	(23,803	)	$	(24,466	)	$	(42,591	)	$	(43,363	)

Weighted-average shares used in computing basic and diluted net loss per share		57,855			53,207			57,764			52,954

Basic and diluted net loss per share	$	(0.41	)	$	(0.46	)	$	(0.74	)	$	(0.82	)

Antidilutive securities not included in net loss per share calculation:
Options to purchase common stock		11,670			10,320			11,670			10,320

3.	Short-term investments

Short-term investments consisted of the following at June 30, 2005 (in thousands):


	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
Type of security:
Corporate debt securities	$	51,157	$	12	$	(266	)	$	50,903
Asset-backed securities		109,761		57		(509	)		109,309
U.S. government and agency securities		61,352		7		(218	)		61,141

	$	222,270	$	76	$	(993	)	$	221,353

Maturity date:
Less than one year	$	124,757						$	124,273
Due in 1-3 years		97,513							97,080

	$	222,270						$	221,353

The Company’s management has concluded that unrealized losses are temporary, as the duration of the decline in the value of the investments has been short; the extent of the decline, both in dollars and percentage of cost is not severe; and the Company has the ability and intent to hold the investments until at least substantially all of the cost of the investments is recovered.

4.	Stock compensation

As permitted by the provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (SFAS 123) as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure (SFAS 148), the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), in accounting for employee stock option grants and apply the disclosure-only provisions of SFAS 123. Under APB 25, compensation expense is based on the excess, if any, of the estimated fair value of its stock at the date of grant over the exercise price of the option. Deferred compensation is amortized over the vesting period of the individual options, using the straight-line method.

The following table illustrates the effect on net loss and loss per share as if the fair value based method prescribed by SFAS 123 had been applied to all outstanding and unvested awards for the three and six-month periods ended June 30 (in thousands, except per share data):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2003
Net loss as reported	$	(23,803	)	$	(24,466	)	$	(42,591	)	$	(43,363	)
Add: employee stock-based compensation under APB 25 included in reported net loss		954			1,534			2,200			3,106
Add: employee stock-based compensation related to the repayment of loans to purchase common stock included in reported net loss		—			3,226			—			3,226
Deduct: employee stock-based compensation expense determined under the fair value method		(4,778	)		(4,044	)		(9,540	)		(7,696	)

Net loss attributable to common shareholders, pro forma	$	(27,627	)	$	(23,750	)	$	(49,931	)	$	(44,727	)

Basic and diluted net loss per share, as reported	$	(0.41	)	$	(0.46	)	$	(0.74	)	$	(0.82	)

Basic and diluted net loss per share, pro forma	$	(0.48	)	$	(0.45	)	$	(0.86	)	$	(0.84	)

5.	Comprehensive loss

For the three and six months ended June 30, 2005, total comprehensive loss was $23.1 million and $42.2 million, respectively. For the three and six months ended June 30, 2004, total comprehensive loss was $26.1 million and $45.1 million, respectively. Comprehensive loss is composed of net loss and unrealized gains and losses on short-term investments. The net change in accumulated other comprehensive loss for the six months ended June 30, 2005 was $342,000, reflecting a decrease in net unrealized losses on short-term investments due to decreasing interest rates.

6.	Reclassification

Certain amounts in the financial statements have been reclassified to conform to the current period’s presentation. The reclassifications had no impact on previously reported net loss.

7.	Recent accounting pronouncements

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. Disclosure of the effect of expensing the fair value of equity compensation is currently required under existing literature (see Note 4 to the financial statements). In March 2005, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 107, Share-Based Payment, which expresses views of the SEC Staff about the application of SFAS 123(R). In April 2005, the SEC adopted a new rule that amends the compliance date for SFAS 123(R) to the beginning of the next fiscal year that begins after June 15, 2005. Accordingly, the Company will be required to begin expensing amounts related to employee stock options effective January 1, 2006. The adoption of SFAS 123(R) will have a material impact on our results of operations. We have begun, but not completed, the process of evaluating the option valuation methods and adoption transition alternatives available under SFAS 123(R). Accordingly, we are not able to provide an estimate of the amount by which our net loss will increase after SFAS 123(R) is adopted.

In June 2005, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 154 (SFAS 154), Accounting Changes and Error Corrections-a replacement of APB No.20 and FAS No.3. SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will apply the provisions of this statement effective January 1, 2006.

Item 2.

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

Forward-Looking Statements

The following discussion and analysis should be read in conjunction with the financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This report contains, in addition to historical information, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” as well as those discussed elsewhere in this report. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. When used in this document, the words “believes,” “expects,” “anticipates,” “intends,” “plans” and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Readers are urged to carefully review and consider the various disclosures made in this report and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations.

Business Overview

We are a biopharmaceutical company focused on discovering, developing and commercializing therapeutic protein based products for the treatment of human diseases. The process for taking one of our discoveries to the marketplace is long, complex and very costly. It is difficult to predict the time and expenditures it would take to commercialize any given product candidate, but it would not be unusual to span ten years or more and cost hundreds of millions of dollars. It is also a business of attrition; it is expected that, for the industry as a whole, less than 20% of the drug candidates entering human clinical trials will actually make it to the marketplace. For the products that do make it, particularly for those that address previously unmet medical needs, the markets can be significant, with a number of successful products selling in excess of $1 billion per year.

An important element of our strategy is that we intend to maintain all or a significant share of the commercial rights to a number of our products in North American markets. As a result, we will be required to pay a significant portion of the development costs for these product candidates. A second important element of our strategy is that we are developing a broad portfolio of product candidates to give our company more opportunities to be successful. We currently have three product candidates in clinical development and expect to add additional proteins to this portfolio in the future. Thus, we are paying a significant portion of development costs for several potential products. Assuming these product candidates progress through clinical development successfully, the costs of clinical trials are expected to increase significantly.

Our most significant financial challenges are to obtain adequate funding to cover the cost of product development, and to control spending and direct it toward product candidates that will create the most value for the company’s shareholders over the long term. It can be a complex and highly subjective process to establish the appropriate balance between cash conservation and value generation. There are a number of important factors that we consider in addressing these challenges, including the following:

•

the nature, timing and magnitude of financing transactions, which would typically involve issuance of equity or equity-based securities;

•

the nature and timing of product development collaborations, which would typically provide for funding of a portion of the respective product development costs, as well as bring in near-term potential revenues in the form of upfront fees and milestone payments;

•

the breadth of product development programs, i.e. the number of potential disease indications for which a product candidate is tested in clinical trials;

•

the number of products in our development portfolio and the decision to move new product candidates into clinical development; and

•

periodic assessments of the relative capital requirements, risk and value of each of our product candidates.

We expect that it will be several years or more before we can generate enough product-related revenues to reach cash flow breakeven. In the interim, revenues from existing relationships will help to defray our expenses, but additional funding will be required, the amount of which could be significant. We may decide to enter into additional product development collaborations, which would reduce our funding requirements. We may also generate funding through licensing of patents that are not relevant to our product development programs.

It is likely that we will continue to look for opportunities to raise equity capital as a primary means of funding our company over the next several years. The equity markets for biotechnology stocks have tended to experience long cycles during which the sale of equity securities has been extremely difficult. It is not possible to predict the timing or length of these cycles. As a result, most biotechnology companies, including ours, have adopted an opportunistic strategy of raising equity capital when it is available. We believe this strategy is important to minimizing the financial risks to our company and our shareholders.

Results of Operations

Revenues

Our revenues generally consist of royalties, option fees, license fees and milestone payments. The recognition of these revenues, in particular license fees and milestone payments, can fluctuate significantly from quarter to quarter. For the year 2005, we continue to expect that our total revenues will slightly exceed those reported for the year 2004.

Royalties. We earn royalties on sales of certain products subject to license agreements with Novo Nordisk, our former parent and current owner of approximately 38% of our outstanding common stock, and several other companies. Royalties generated from underlying human insulin sales have decreased in 2005 to $736,000 and $2.0 million for the three and six-month periods ended June 30, 2005, respectively, as compared to $1.3 million and $2.7 million for the corresponding periods in 2004, due to patent expirations in certain countries and unfavorable changes in foreign exchange rates. We expect this trend to continue, and expect total 2005 royalty revenue to be in the range of $7 million to $8 million. We have opportunities to earn royalties in the future under other existing license agreements, but we cannot be certain when, or if, products will be sold subject to those licenses.

Option fees. We recognized $2.7 million and $5.3 million for the three and six-month periods ended June 30, 2005 as compared to $1.9 million and $3.8 million for the corresponding periods in 2004. The increases represent the recognition of deferred revenue related to a strategic alliance with Serono entered into during the fourth quarter of 2004. The $1.9 million related-party option fee per quarter recorded in both years represents the annual option fee of $7.5 million from Novo Nordisk under an option and license agreement, pursuant to which we have granted an option to license certain rights to proteins that we discover.

License fees and milestone payments. Revenues from license fees and other up-front payments are recognized over the period we are contractually required to provide other rights or services that represent continuing obligations. Revenue from license fees and milestone payments decreased by $595,000 for the

quarter ended June 30, 2005 compared to the corresponding period in 2004, but has increased by $4.9 million for the six-month period ended June 30, 2005 compared to the corresponding period in 2004. This increase was primarily due to a one-time, lump sum license fee received and earned from Eli Lilly and Company in the first quarter of 2005 for a license to certain Protein C patents, and the recognition of deferred revenue related to the licenses of rFXIII to Novo Nordisk and certain other proteins to Serono, all of which were entered into during the fourth quarter of 2004. The decrease in this revenue item for the quarter ended June 30, 2005 was attributable to an upfront payment from a license agreement with Amgen, Inc. that was recognized as revenue in the quarter ended June 30, 2004. From period to period, this revenue item can fluctuate substantially based on the completion of new licensing or collaborative agreements and the achievement of development related milestones. Although this revenue item increased for the first six-months of 2005, we cannot be certain this trend will continue for the remainder of 2005 and beyond due to the uncertain nature of the events generating the revenue.

Expenses

Research and development. Research and development expense has been our most significant expense to date, consisting primarily of salaries and benefit expenses, costs of consumables, facility costs and contracted services. Research and development expense, net of cost reimbursements, increased by 6% and 13% for the three and six-month periods ended June 30, 2005 as compared to the corresponding periods in 2004. The increases largely resulted from significantly increased activities for the development of our three product candidates undergoing clinical trials, rhThrombin, TACI-Ig and IL-21. The addition of approximately 50 employees between June 30, 2004 and June 30, 2005 who are focused on product development led to higher salaries and benefits costs. In addition, we have experienced a significant increase in consumable costs to supply our recently completed pilot-scale manufacturing facility and establish initial stocks of raw materials. These trends for the three and six-month periods ended June 30 are shown in the following table (in thousands):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Salaries and benefits	$	11,102		$	9,576		$	21,876		$	19,027
Consumables		3,028			2,324			7,101			4,152
Facility costs		1,495			1,451			3,112			2,669
Contracted services		9,133			8,676			15,935			14,601
Depreciation and amortization		1,279			1,141			2,568			2,150
Noncash stock-based compensation		812			1,627			1,748			2,645

Subtotal		26,849			24,795			52,340			45,244
Cost reimbursement from collaborators		(961	)		(322	)		(1,921	)		(690	)

Net research and development expense	$	25,888		$	24,473		$	50,419		$	44,554

We anticipate that research and development expense will continue to increase in the foreseeable future as we continue to advance, and potentially expand, our internal product development programs. In 2005, we expect that a number of factors, including the following, will contribute to an increase in research and development expense.

•

costs of expanded clinical trial activity for ongoing product development programs;

•

increased staffing to support the expansion and advancement of product development programs, particularly in the clinical, medical, regulatory, manufacturing and quality areas; and

•

costs of operating our new pilot-scale manufacturing facility.

Partially offsetting these factors, we have shifted the manufacture of rhThrombin registration lots from late 2005 to early 2006, thus deferring significant contract expenses. For the full year 2005, we continue to expect that our research and development expenses will increase by less than 10% compared to 2004.

General and administrative. General and administrative expense consists primarily of salaries and benefit expenses, professional fees and other corporate costs. Expense decreased 23% for the quarter ended June 30, 2005 as compared to the corresponding period in 2004, primarily due to a decrease in noncash stock-based compensation of $3.0 million. In the second quarter of 2004, we recorded a one-time compensation expense charge of $3.2 million related to the repayment of loans by certain executives with shares of common stock originally purchased with the loan proceeds. Excluding this charge, general and administrative expense increased in both the three and six-month periods. A significant part of the increases related to increased strategic marketing activities in support of our product development programs, especially rhThrombin. General increases in headcount costs and professional fees also contributed to the increases. We anticipate that our general and administrative requirements will increase to support our development programs as they advance towards commercialization. For the full year 2005, we continue to expect an increase in general and administrative expense, exclusive of noncash stock-based compensation, of up to 25% as compared to 2004.

Noncash stock-based compensation. In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. Disclosure of the effect of expensing the fair value of equity compensation is currently required under existing literature (see Note 4 to the financial statements). SFAS 123(R) will become effective for fiscal years beginning after June 15, 2005. Accordingly, we will be required to begin expensing amounts related to employee stock options effective January 1, 2006. The adoption of SFAS 123(R) will have a material impact on our results of operations. We have begun, but not completed, the process of evaluating the option valuation methods and adoption transition alternatives available under SFAS 123(R). Accordingly, we are not able to provide an estimate of the amount by which our net loss will increase after SFAS 123(R) is adopted.

Other income (expense)

Investment income. Investment income is generated primarily from investment of our cash reserves in investment grade, fixed-income securities. There are three primary factors affecting the amount of investment income that we report: amount of cash reserves invested, the effective interest rate, and the amount of gains or losses recognized. Investment income increased significantly for the three and six-month periods ended June 30, 2005 as compared to the corresponding periods in 2004, largely due to increases in the effective interest rate realized. The following table shows how each of these factors affected investment income for the following (in thousands):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Weighted average amount of cash reserves	$	282,785		$	273,213		$	295,624		$	280,141
Effective interest rate		0.70	%		0.40	%		1.30	%		0.84	%

Investment income before gains and losses		1,988			1,105			3,829			2,345
Net gains (losses) on sales of investments		(157	)		(157	)		(380	)		5

Investment income, as reported	$	1,831		$	948		$	3,449		$	2,350

Interest expense. We have accounted for a sale-leaseback transaction completed in October 2002 as a financing transaction. Under this method of accounting, an amount equal to the net proceeds of the sale is

considered a long-term interest bearing liability. Rent payments under the leases are considered to be payments toward the liability and are allocated to principal and interest. Interest expense increased to $1.9 million and $3.8 million for the three and six-month periods ended June 30, 2005 as compared to $1.7 million and $3.1 million for the corresponding periods in 2004. The increases resulted from the increase in our lease obligations by approximately $15 million upon completion of our facility expansion project in mid-2004.

Liquidity and Capital Resources

As of June 30, 2005, we had cash, cash equivalents and short-term investments of $275.1 million, which we intend to use to fund our operations and capital expenditures over the next several years. These cash reserves are held in a variety of investment-grade, fixed-income securities, including corporate bonds, commercial paper and money market instruments. We believe that our existing cash resources should provide sufficient funding through late 2007. If we complete additional collaborative development transactions, which would generate both revenues and cost reductions, we believe that these cash resources may fund our company for a longer period of time.

Cash flows from operating activities. The amount of cash used to fund our operating activities generally tracks our net losses, with the following exceptions:

•

noncash expenses, such as depreciation and amortization, gain or loss on sale or disposal of assets, and noncash stock-based compensation, which do not result in uses of cash;

•

net realized gains and losses and amortization of premium on short-term investments, which are reflected as sources of cash from investing activities upon maturity or sale of the respective investments;

•

changes in receivables, which generally represent temporary timing differences between the recognition of certain revenues and the subsequent receipt of cash payments;

•

changes in deferred revenue, which reflect the difference in timing between the receipt of cash from option fees, license fees and other upfront payments and the subsequent recognition of these amounts as revenue over the period we are contractually required to provide other rights or services that represent continuing obligations; and

•

changes in other assets and liabilities, which generally represent temporary timing differences between the recognition of certain expenses and their payment.

Generally, with the exception of changes in deferred revenue, we do not expect these items to generate material year-to-year fluctuations in the relationship between our net loss and the amount of net cash used in operating activities. Substantial license or upfront fees may be received upon the date we enter into new licensing or collaborative agreements and be recorded as deferred revenue. For example, in 2004 upon the execution of a strategic alliance agreement with Serono and a license agreement with Novo Nordisk, we recorded $36.2 million of deferred revenue, which will be recognized as revenue over the next approximately five years. For the six months ended June 30, 2005, we recognized $12.1 million of deferred revenue from these and other transactions causing our cash used in operating activities to be higher than our corresponding net loss. The timing of additional deferred revenue transactions is expected to be irregular and, thus, has the potential to create fluctuations in the relationship between our net loss and the amount of cash used in operating activities.

Cash flows from investing activities. Our most significant use of cash in investing activities is for capital expenditures. We expend a certain amount each year on routine items to maintain the effectiveness of our business, e.g., to adopt newly developed technologies, expand into new functional areas, adapt our facilities to changing needs and/or replace obsolete assets. In addition, we have used cash to purchase land and expand our facilities. The following table shows the amount of cash going toward each of these types of capital expenditures for the six months ended June 30 (in thousands):


	2005		2004
Routine equipment/facility expenditures	$	2,677	$	2,012
Expansion of R&D facility, including pilot scale manufacturing plant		388		8,283

Total	$	3,065	$	10,295

The R&D facility expansion project was partially funded by an allowance from our landlord, which is reflected as cash flow from financing activities. The project began in April 2003 and construction was completed in mid-2004. We expect to spend approximately $6 million to $8 million in 2005 on routine capital equipment and facility projects.

Cash flows from investing activities also reflect large amounts of cash used to purchase short-term investments and received from the sale and maturity of short-term investments. These amounts primarily relate to shifts between cash and cash equivalents and short-term investments. Because we manage our cash usage with respect to our total cash, cash equivalents and short-term investments, we do not consider these cash flows to be important to an understanding of our liquidity and capital resources.

Cash flows from financing activities. In May 2004, we entered into a stock purchase agreement with Amgen, Inc. under which they agreed to purchase 624,337 shares of our common stock. We received net proceeds of approximately $10 million. As part of the agreement for the expansion of our R&D facility, our landlord provided us an allowance of approximately $15 million to be applied toward the cost of this project. We received $6.9 million through the quarter ended June 2004, which represented the final installment of construction advance payments from our landlord.

We expect to incur substantial additional costs as we continue to advance and expand our product development programs. We expect these expenditures to increase over the next several years, particularly if the outcomes of clinical trials are successful. Our plans include the internal development of selected product candidates and the co-development of product candidates with collaborators where we would assume a percentage of the overall product development costs. If, at any time, our prospects for financing these programs decline, we may decide to reduce our ongoing investment in our development programs. We could reduce our investment by discontinuing our funding under existing co-development arrangements, establishing new co-development arrangements for other product candidates to provide additional funding sources or out-licensing product candidates that we might otherwise develop internally. Additionally, we could consider delaying or discontinuing development of product candidates to reduce the level of our related expenditures.

Our long-term capital requirements and the adequacy of our available funds will depend on several factors, many of which may not be in our control, including:

•

results of research and development programs;

•

cash flows under existing and potential future arrangements with licensees, collaborators and other parties;

•

costs involved in filing, prosecuting, enforcing and defending patent claims; and

•

costs associated with the expansion of our facilities.

Over the next several years we will need to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements sooner than we expect. However, financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or equity-based securities, the percentage ownership of our existing shareholders would be reduced, and these securities could have rights superior to those of our common stock. If we are unable to raise additional funds when we need them, we could be required to delay, scale back or eliminate expenditures for some of our development programs or expansion plans, or

grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally, with license terms that are not favorable to us.

Contractual Obligations

At June 30, 2005 we are contractually obligated to make payments as follows (in thousands):


	Payments Due by Period
	Total		Less than 1 Year		1-3 Years		3-5 Years		More than 5 Years
Building lease obligations	$	126,664	$	7,227	$	15,222	$	16,307	$	87,908
Operating leases		8,246		1,186		2,464		2,529		2,067
Development contracts		13,559		12,344		1,215		—		—

Total	$	148,469	$	20,757	$	18,901	$	18,836	$	89,975

The building lease obligations, which resulted from the sale-leaseback financing transaction, reflect the reset of the lease terms to 15 years beginning May 2004. Operating lease terms range from one to ten years. We have certain renewal provisions at our option, which are not reflected in the above table, for the building leases and the operating leases. The development contracts include the production of Phase 3 supply and registration lots of rhThrombin, which may also be used for commercial purposes.

Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price

A summary of important factors that may affect our business, our results of operations and our stock price follows. You should refer to our Annual Report or Form 10-K for the year ended December 31, 2004 for a more thorough discussion of these factors. The risks and uncertainties identified below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the risks identified in the factors below actually occur, our business, financial condition and operating results could be materially adversely affected.

Product Development Risks

•

We have limited experience in developing products.

•

Any failure or delay in commencing or completing clinical trials for product candidates could severely harm our business.

•

Clinical trials may fail to demonstrate the safety and effectiveness of our product candidates, which could prevent or significantly delay their regulatory approval.

•

We may be unable to satisfy the rigorous government regulations relating to the development and commercialization of our product candidates.

•

Because we currently have only limited capabilities to manufacture materials for clinical trials and no capability for commercial scale manufacturing, we will have to rely on third parties to manufacture our potential products, and we may be unable to obtain required quantities in a timely manner or on acceptable terms, if at all.

•

We may not be successful in developing internal manufacturing capabilities or complying with applicable manufacturing regulations.

•

Because we will depend on third parties to conduct laboratory tests and clinical trials, we may encounter delays in or lose some control over our efforts to develop product candidates.

•

Because we currently have no sales capabilities and limited marketing capabilities, we may be unable to successfully commercialize our potential products.

Technological Risks

•

Our bioinformatics-based discovery strategy is unproven, and genes or proteins we have discovered may have no commercial value.

•

The availability of novel genomic data continues to decrease, which negatively affects our ability to discover entirely novel therapeutic proteins.

Intellectual Property Risks

•

Our patent applications may not result in issued patents, and our competitors may commercialize the discoveries we attempt to patent.

•

Third parties may infringe our patents or challenge their validity or enforceability.

•

We may be subject to patent infringement claims, which could result in substantial costs and liability and prevent us from commercializing our potential products.

•

Issued patents may not provide us with any competitive advantage or provide meaningful protection against competitors.

•

The patent field relating to therapeutic protein-based products is subject to a great deal of uncertainty, and if patent laws or the interpretation of patent laws change, our competitors may be able to develop and commercialize products based on proteins that we discovered.

•

We expect to incur significant expenses in applying for patent protection and prosecuting our patent applications.

•

We may be unable to protect our unpatented proprietary technology and information.

General Business Risks

•

Our plan to use collaborations to leverage our capabilities may not be successful.

•

We may not be able to generate any revenue from product candidates developed by collaborators or licensees if they are unable to successfully develop those candidates.

•

Novo Nordisk and Serono have substantial rights to license proteins we discover, which may limit our ability to pursue other collaboration or licensing arrangements or maximize the benefit from our discoveries.

•

Environmental and health and safety laws may result in liabilities, expenses and restrictions on our operations.

Financial and Market Risks

•

We anticipate incurring additional losses and may not achieve profitability.

•

If we do not obtain substantial additional funding on acceptable terms, we may not be able to continue to grow our business or generate enough revenue to recover our investment in research and development.

•

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

Industry Risks

•

Many of our competitors have substantially greater capabilities and resources than we do and may be able to develop and commercialize products before we do.

•

Our product candidates, even if approved by the FDA or foreign regulatory agencies, may not achieve market acceptance among hospitals, insurers or patients.

•

If the health care system, reimbursement policies or any other health care related regulations change, the prices of our potential products may fall or our potential sales may decline.

•

Negative public opinion and increased regulatory scrutiny of genetic and clinical research may limit our ability to conduct our business.

•

The failure to attract or retain key management or other personnel could decrease our ability to discover, develop and commercialize potential products.

•

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

Other Risks

•

Our stock price may be volatile.

•

Certain of our shareholders have significant control of our management and affairs, which they could exercise against other shareholders’ best interests.

•

Provisions in our charter documents could prevent or frustrate any attempts to replace our current board of directors or management by shareholders.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk is primarily limited to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of our investments are in short-term debt securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain our portfolio of cash, cash equivalents and short-term investments in a variety of interest-bearing instruments, including United States government and agency securities, high-grade United States corporate bonds, asset-backed securities, commercial paper and money market funds. Due to the nature of our short-term investments, all of which mature within three years, we believe that we are not subject to any material market risk exposure. We have no material foreign currency exposure, nor do we hold derivative financial instruments.

Item 4.

Controls and Procedures

Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report, have concluded that as of such date our disclosure controls and procedures were effective. No change in our internal control over financial reporting occurred during the quarter ended June 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

(b)

Use of Proceeds from Sale of Registered Securities

Our Registration Statement under the Securities Act of 1933 (File No. 333-69190) relating to our initial public offering, was declared effective by the SEC on January 31, 2002. From the effective date of the offering through June 30, 2005, we have invested the net proceeds from the offering in a variety of investment grade, fixed income securities, including corporate bonds, commercial paper and money market instruments.

Item 4.

Submission of Matters to a Vote of Security Holders

We held our annual meeting of shareholders on June 10, 2005. Of the 57,808,556 shares of common stock outstanding as of the record date of the annual meeting, 54,411,605 shares, or 94.1% of the total shares eligible to vote at the annual meeting, were represented in person or by proxy. One proposal was submitted to our shareholders and approved at the annual meeting, as follows:

Election of Directors. Jonathan S. Leff, George B. Rathmann, Ph.D. and Lars Rebien Sørensen were elected to serve as members of the board of directors, each with terms expiring in 2008. James A. Harper and David H. MacCallum were elected to serve as members of the board of directors, with terms expiring in 2007 and 2006, respectively. The number of votes cast for or withheld from each nominee, both in person and by proxy, was as follows:


Name	Votes For	Votes Withheld
Jonathan S. Leff	52,876,533	1,535,072
George B. Rathmann, Ph.D.	50,919,117	3,492,488
Lars Rebien Sørensen	51,023,978	3,387,627
James A. Harper	52,922,259	1,489,346
David H. MacCallum	52,922,273	1,489,332

David I. Hirsh, Ph.D., Kurt Anker Nielsen, Bruce L.A. Carter, Ph.D. and Edward E. Penhoet, Ph.D. had continuing terms as directors.

Item 6.

Exhibits


Exhibit Number

31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		ZYMOGENETICS, INC.

Date:	July 28, 2005	By:	/s/ James A. Johnson
			James A. Johnson Senior Vice President and Chief Financial Officer (Principal Financial Officer and Authorized Officer)

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