INCY

Business Context and Reporting Period

Company: Incyte Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2006
Business Overview: Incyte is a biopharmaceutical company focused on the discovery and development of novel drugs for oncology, inflammation, diabetes, and HIV. The company operates as a single segment: drug discovery and development.

Key Financial Metrics

Note: Total Debt includes $151.8M in 3.5% Senior Notes, $250.0M in 3.5% Subordinated Notes, $91.6M in 5.5% Notes (redeemed Oct 2006), and $10.0M Pfizer Note.

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased significantly to $20.6 million for the nine months ended September 30, 2006, compared to $6.8 million in the prior year. This was driven primarily by $18.1 million in contract revenues from a new collaboration with Pfizer, whereas the prior year had no contract revenues.
• Reduced Net Loss: Net loss improved to $53.7 million (9 months 2006) from $75.5 million (9 months 2005). The improvement is attributed to higher Pfizer-related revenues and lower R&D expenses due to the discontinuation of the DFC program and the Pfizer collaboration.
• Debt Financing: In September 2006, the company issued $151.8 million in 3.5% Convertible Senior Notes due 2011, receiving $111.9 million in proceeds. This significantly improved liquidity.
• Accounting Change: Adoption of SFAS 123R (Share-Based Payment) on January 1, 2006, resulted in the recognition of $6.6 million in stock-based compensation expense for the nine months ended September 30, 2006, which was not recorded in the prior year.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• Liquidity: Management believes cash, cash equivalents, and marketable securities ($444.1 million total) are adequate to satisfy capital needs for at least the next twelve months.
• Future Losses: The company anticipates incurring additional losses for several years as it expands drug discovery and development programs. Losses are expected to fluctuate substantially quarter-to-quarter.
• Revenue Trends: Revenues from information products (database subscriptions) are expected to continue to decline as the company focuses on drug development.

Risks and Contingencies

• Development Risk: The company is in early stages of drug development. Discontinuation of the DFC program in April 2006 highlights the risk of failed clinical trials.
• Collaboration Dependence: Significant reliance on Pfizer for the development and commercialization of CCR2 antagonist compounds. Pfizer has the right to terminate the agreement with 90 days' notice.
• Debt Obligations: High leverage with $503.4 million in aggregate principal debt. The company may not generate sufficient cash flow from operations to meet debt service requirements without raising additional capital or liquidating securities.
• Legal Proceedings: Settled patent litigation with Invitrogen in June 2006 for $3.4 million. Management believes other ongoing legal actions will not have a material adverse effect.

Investor Verification Checklist

• Pfizer Collaboration Terms: Verify the specific milestones and royalty rates associated with the $803 million potential upside from the Pfizer agreement.
• Cash Burn Rate: Monitor the rate of cash consumption given the $53.7 million net loss and $28.2 million cash used in operating activities for the nine-month period.
• Debt Redemption: Confirm the impact of the October 2006 redemption of the $91.6 million 5.5% Notes on future interest expenses and liquidity.
• Clinical Trial Progress: Track the status of the three active clinical programs (sheddase inhibitor, 11bHSD1 inhibitor, and CCR5 antagonist) as these are the primary drivers for future profitability.
• Stock-Based Compensation: Review future stock option grants and forfeiture rates, as SFAS 123R adoption significantly impacts reported net loss.