PDL BioPharma, Inc.
PDL BIOPHARMA, INC. (Form: 10-Q, Received: 11/05/2012 16:11:51)
 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 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 September 30, 2012
   
  
OR
¨
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
   
 
For transition period from               to            
   
Commission File Number: 000-19756

PDL BIOPHARMA, INC.
(Exact name of registrant as specified in its charter)

Delaware
94-3023969
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification Number)
 
 
932 Southwood Boulevard
Incline Village, Nevada 89451
(Address of principal executive offices and Zip Code)
 
(775) 832-8500
(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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes   x     No   ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer x
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company ¨
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    Yes   ¨     No   x
 
As of November 1, 2012, there were 139,933,204 shares of the Registrant’s Common Stock outstanding.
 
 
 

 
 
  PDL BIOPHARMA, INC.
2012 Form 10-Q
Table of Contents
 
 
Page
PART I - FINANCIAL INFORMATION
     
ITEM 1.
FINANCIAL STATEMENTS
3
     
 
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2012 and 2011
3
     
 
Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2012 and 2011
4
     
 
Condensed Consolidated Balance Sheets at September 30, 2012, and December 31, 2011
5
     
 
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011
6
     
 
Notes to the Condensed Consolidated Financial Statements
7
     
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
21
     
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
32
     
ITEM 4.
CONTROLS AND PROCEDURES
34
 
PART II - OTHER INFORMATION
     
ITEM 1.
LEGAL PROCEEDINGS
35
     
ITEM 1A.
RISK FACTORS
37
     
ITEM 6.
EXHIBITS
38
   
SIGNATURES
39
 
We own or have rights to certain trademarks, trade names, copyrights and other intellectual property used in our business, including PDL BioPharma and the PDL logo, each of which is considered a trademark. All other company names, product names, trade names and trademarks included in this Quarterly Report are trademarks, registered trademarks or trade names of their respective owners.
 
 
2

 
 
PART I. FINANCIAL INFORMATION
 
ITEM  1.         FINANCIAL STATEMENTS
 
PD L BIOPHARMA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share amounts)

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Revenues
                       
Royalties
  $ 85,231     $ 83,370     $ 288,479     $ 278,833  
License and other
    -       400       -       10,400  
Total revenues
    85,231       83,770       288,479       289,233  
                                 
Operating expenses
                               
General and administrative
    5,647       3,960       17,737       13,516  
Operating income
    79,584       79,810       270,742       275,717  
                                 
Non-operating expense, net
                               
Loss on retirement or conversion of convertible notes
    -       -       -       (766 )
Interest and other income, net
    1,867       130       2,385       463  
Interest expense
    (6,514 )     (9,007 )     (23,087 )     (27,941 )
Total non-operating expense, net
    (4,647 )     (8,877 )     (20,702 )     (28,244 )
                                 
Income before income taxes
    74,937       70,933       250,040       247,473  
Income tax expense
    26,362       25,017       87,779       87,026  
Net income
  $ 48,575     $ 45,916     $ 162,261     $ 160,447  
                                 
Net income per share
                               
Basic
  $ 0.35     $ 0.33     $ 1.16     $ 1.15  
Diluted
  $ 0.32     $ 0.28     $ 1.08     $ 0.88  
                                 
Weighted average shares outstanding
                               
Basic
    139,715       139,680       139,693       139,665  
Diluted
    149,626       167,019       150,678       186,756  
                                 
Cash dividends declared per common share
  $ -     $ -     $ 0.60     $ 0.60  
 
 
See accompanying notes.
 
 
3

 
 
PDL BIOPHARMA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 (Unaudited)
(In thousands)

 

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Net income
  $ 48,575     $ 45,916     $ 162,261     $ 160,447  
                                 
Other comprehensive income (loss), net of tax
                               
Unrealized losses on investments in available-for-sale securities
    (14 )     (55 )     (1 )     (8 )
Unrealized gains (losses) on cash flow hedges
    (3,126 )     4,281       (853 )     (4,981 )
Total other comprehensive income (loss), net of tax
    (3,140 )     4,226       (854 )     (4,989 )
Comprehensive income
  $ 45,435     $ 50,142     $ 161,407     $ 155,458  
 

See accompanying notes.
 
 
4

 
 
PDL BIOPHARMA, INC.
CONDENSED CONS OLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
 
   
September 30,
2012
   
December 31,
2011
 
   
(unaudited)
   
(Note 1)
 
Assets            
Current assets:
           
Cash and cash equivalents
  $ 132,590     $ 168,544  
Restricted investment
    20,000       -  
Short-term investments
    27,777       42,301  
Receivables from licensees
    -       600  
Deferred tax assets
    3,552       10,054  
Notes receivable
    13,182       -  
Prepaid and other current assets
    5,775       12,014  
Total current assets
    202,876       233,513  
                 
Property and equipment, net
    30       22  
Long-term investments
    -       17,101  
Notes receivable
    33,490       -  
Long-term deferred tax assets
    6,162       11,481  
Other assets
    7,338       7,354  
Total assets
  $ 249,896     $ 269,471  
                 
Liabilities and Stockholders' Deficit
               
Current liabilities:
               
Accounts payable
  $ 813     $ 528  
Accrued legal settlement
    -       27,500  
Accrued liabilities
    31,483       11,609  
Current portion of non-recourse notes payable
    -       93,370  
Total current liabilities
    32,296       133,007  
                 
Convertible notes payable
    307,337       316,615  
Other long-term liabilities
    25,747       24,122  
Total liabilities
    365,380       473,744  
                 
Commitments and contingencies (Note 8)
               
                 
Stockholders' deficit:
               
Preferred stock, par value $0.01 per share, 10,000 shares authorized; no shares issued and outstanding
    -       -  
Common stock, par value $0.01 per share, 250,000 shares authorized; 139,724 and 139,680 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively
    1,397       1,397  
Additional paid-in capital
    (234,368 )     (161,750 )
Accumulated other comprehensive loss
    (2,739 )     (1,885 )
Retained earnings (accumulated deficit)
    120,226       (42,035 )
Total stockholders' deficit
    (115,484 )     (204,273 )
Total liabilities and stockholders' deficit
  $ 249,896     $ 269,471  

 See accompanying notes.
 
 
5

 
 
PDL BIOPHARMA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
   
Nine Months Ended
September 30,
 
   
2012
   
2011
 
Cash flows from operating activities
           
Net income
  $ 162,261     $ 160,447  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Discounts and deferred issuance costs
    10,507       7,342  
Other amortization, depreciation and accretion
    804       1,032  
Loss on retirement or conversion of convertible notes
    -       766  
Hedge adjustment - ineffectiveness and reclassifications from OCI for transactions probable of not occuring
    (372 )     -  
Stock-based compensation expense
    675       256  
Tax expense from stock-based compensation arrangements
    (42 )     (120 )
Deferred taxes
    6,523       25,117  
Changes in assets and liabilities:
               
Receivables from licensees
    600       469  
Prepaid and other current assets
    5,266       1,881  
Other assets
    (1,163 )     (6,642 )
Accounts payable
    285       (2,655 )
Accrued legal settlement
    (27,500 )     (37,500 )
Accrued liabilities
    2,028       1,342  
Other long-term liabilities
    (1,250 )     (27,099 )
Net cash provided by operating activities
    158,622       124,636  
Cash flows from investing activities
               
Purchases of investments
    (25,992 )     (71,697 )
Maturities of investments
    36,799       39,146  
Issuance of notes receivable
    (48,264 )     -  
Acquisition of property and equipment
    (18 )     -  
Net cash used in investing activities
    (37,475 )     (32,551 )
Cash flows from financing activities
               
Repurchase of convertible notes
    -       (134,464 )
Repayment of non-recourse notes
    (93,370 )     (89,002 )
Payment of debt issuance costs
    (845 )     -  
Net proceeds from the issuance of convertible notes
    -       149,712  
Purchase of call options
    -       (20,765 )
Proceeds from issue of warrants
    -       10,868  
Cash dividends paid
    (62,886 )     (62,876 )
Net cash used in financing activities
    (157,101 )     (146,527 )
Net decrease in cash and cash equivalents
    (35,954 )     (54,442 )
Cash and cash equivalents at beginning of the year
    168,544       211,574  
Cash and cash equivalents at end of period
  $ 132,590     $ 157,132  
                 
                 
Supplemental cash flow information
               
Cash paid for income taxes
  $ 76,000     $ 66,000  
Cash paid for interest
  $ 12,843     $ 20,004  
 
See accompanying notes.  
 
 
6

 
 
PDL BIOPHARMA, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2012
(Unaudited)
 
1. Summary of Significant Accounting Policies
 
Basis of Presentation
 
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information. The financial statements include all adjustments (consisting only of normal recurring adjustments) the management of PDL BioPharma, Inc. (the Company, PDL, we, us or our) believes are necessary for a fair presentation of the periods presented. These interim financial results are not necessarily indicative of results expected for the full fiscal year or for any subsequent interim period.
 
The accompanying Condensed Consolidated Financial Statements and related financial information should be read in conjunction with the audited Consolidated Financial Statements and the related notes thereto for the year ended December 31, 2011, included in our Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission. The Condensed Consolidated Balance Sheet at December 31, 2011, has been derived from the audited Consolidated Financial Statements at that date.
 
Principles of Consolidation
 
The Consolidated Financial Statements include the accounts of PDL and its wholly-owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation.
 
Notes Receivable

We account for our notes receivable at amortized cost, net of unamortized origination fees, if any.  Related fees and costs are recorded net of amounts reimbursed.  Interest is accreted or accrued to interest income using the interest method.

Customer Concentration
 
The percentage of total revenue earned from our licensees’ net product sales, which individually accounted for ten percent or more of our total revenues, was:
       
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
Licensee
 
Product Name
 
2012
   
2011
   
2012
   
2011
 
Genentech, Inc. (Genentech)
 
Avastin ®
    30 %     28 %     31 %     30 %
   
Herceptin ®
    36 %     38 %     35 %     34 %
   
Lucentis ®
    15 %     15 %     18 %     16 %
                                     
Elan Corporation, Plc (Elan)
 
Tysabri ®
    14 %     14 %     12 %     11 %

Foreign Currency Hedging
 
We enter into foreign currency hedges to manage exposures arising in the normal course of business and not for speculative purposes.

We hedge certain Euro-denominated currency exposures related to our licensees’ product sales with Euro forward contracts and, in 2011, Euro forward and option contracts. In general, these contracts are intended to offset the underlying Euro market risk in our royalty revenues. These contracts extend through the fourth quarter of 2014. We designate foreign currency exchange contracts used to hedge royalty revenues based on underlying Euro-denominated sales as cash flow hedges.
 
 
7

 

At the inception of the hedging relationship and on a quarterly basis, we assess hedge effectiveness. The fair value of the Euro forward contracts is estimated using pricing models with readily observable inputs from actively quoted markets and is disclosed on a gross basis. The aggregate unrealized gain or loss, net of tax, on the effective portion of the hedge is recorded in stockholders’ deficit as accumulated other comprehensive income (loss). Gains or losses on cash flow hedges are recognized as an adjustment to royalty revenue in the same period that the hedged transaction impacts earnings as royalty revenue. Any gain or loss on the ineffective portions is reported in other income in the period the ineffectiveness occurs.

During the third quarter of 2012, we de-designated and terminated a portion of our cash flow hedges. The gain realized was reclassified from other comprehensive income (loss) to other income in the third quarter. See Note 5 for additional information on our foreign currency hedge transactions.

Comprehensive Income
 
In the first quarter of 2012, we adopted Financial Accounting Standards Board (FASB) accounting standard update (ASU) 2011-05, and have presented the components of other comprehensive income (loss) in the Condensed Consolidated Statements of Comprehensive Income. Also in accordance with this ASU, we have applied this guidance retrospectively to all periods presented. The adoption of the guidance was a change to the presentation of other comprehensive income (loss) and had no effect on our condensed consolidated financial statements. See Note 14 for our discussion of accumulated other comprehensive income (loss).
 
Recent Accounting Pronouncements
 
In December 2011, the FASB issued ASU 2011-11 requiring new disclosures associated with offsetting financial instruments and derivative instruments on the balance sheet that will enable users to evaluate the effect on an entity’s financial position. The ASU will be effective in the first quarter of 2013, but is not expected to have a material impact on our financial statements.
 
2. Net Income per Share
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
Net Income per Basic and Diluted Share:
 
2012
   
2011
   
2012
   
2011
 
   
(In thousands except per share amounts)
       
Numerator
                       
Net income used to compute net income per basic share
  $ 48,575     $ 45,916     $ 162,261     $ 160,447  
Add back interest expense for convertible notes, net of estimated tax of approximately $4,000 and $0.5 million for the three months ended September 30, 2012 and 2011, respectively and approximately $21,000 and $1.8 million for the nine months ended September 30, 2012 and 2011, respectively (see Note 9)
    6       841       40       3,391  
Income used to compute net income per diluted share
  $ 48,581     $ 46,757     $ 162,301     $ 163,838  
                                 
Denominator
                               
Total weighted-average shares used to compute net income per basic share
    139,715       139,680       139,693       139,665  
Restricted stock outstanding
    110       12       93       21  
Effect of dilutive stock options
    18       13       16       13  
Assumed conversion of Series 2012 Notes
    7,008       -       7,427       -  
Assumed conversion of May 2015 Notes
    2,609       -       2,825       -  
Assumed conversion of February 2015 Notes
    166       27,314       624       27,314  
Assumed conversion of 2012 Notes
    -       -       -       19,743  
Weighted-average shares used to compute net income per diluted share
    149,626       167,019       150,678       186,756  
                                 
Net income per basic share
  $ 0.35     $ 0.33     $ 1.16     $ 1.15  
Net income per diluted share
  $ 0.32     $ 0.28     $ 1.08     $ 0.88  

We compute net income per basic share using the weighted-average number of shares of common stock outstanding during the period less the weighted-average number of restricted stock shares that are subject to repurchase.
 
 
8

 
 
We compute net income per diluted share using the sum of the weighted-average number of common and common equivalent shares outstanding. Common equivalent shares used in the computation of net income per diluted share include shares that may be issued under our stock options and restricted stock awards, our 2.875% Convertible Senior Notes due February 15, 2015 (February 2015 Notes), our 2.875% Series 2012 Convertible Notes due February 15, 2015 (Series 2012 Notes), our 3.75% Senior Convertible Notes due May 1, 2015 (May 2015 Notes) and, in 2011, our 2.00% Convertible Senior Notes due February 15, 2012 (2012 Notes), on a weighted average basis for the period that the notes were outstanding, including the effect of adding back interest expense, net of tax, and the underlying shares using the if-converted method. Our 2012 Notes were fully retired as of September 30, 2011, and $179.0 million aggregate principal amount of our February 2015 Notes was exchanged for our Series 2012 Notes in the first quarter of 2012.
 
The Series 2012 Notes and May 2015 Notes are net share settled, with the principal amount settled in cash and the excess settled in our common stock. The weighted-average share adjustments related to our Series 2012 Notes and May 2015 Notes include the shares issuable in respect of such excess. The May 2015 Notes had no dilutive effect for the periods ended September 30, 2011.  The conversion price of the May 2015 Notes exceeded the market price of our common stock for those periods so no stock was issuable upon conversion.

We excluded 19.2 million and 17.5 million shares of potential dilution for our warrants for the periods ended September 30, 2012 and 2011, respectively, because the exercise price of the warrants exceeded the average market price of our common stock and thus, for the periods presented, no stock was issuable upon conversion. These securities could be dilutive in future periods. Our purchased call options will always be anti-dilutive and therefore 22.6 million and 20.6 million shares were excluded for the periods ended September 30, 2012 and 2011, respectively, because they have no effect on diluted net income per share under GAAP.  For further information related to our convertible notes, see Note 9.
  
We excluded approximately 144,000 and 164,000 shares underlying outstanding stock options, calculated on a weighted average, from our net income per diluted share calculations for the three and nine months ended September 30, 2012, respectively, and approximately 174,000 and 199,000 shares for the three and nine months ended September 30, 2011, respectively, because their effect was anti-dilutive.
 
  3. Fair Value Measurements
 
The fair value of our financial instruments are estimates of the amounts that would be received if we were to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date or exit price. The assets and liabilities are categorized and disclosed in one of the following three categories:

Level 1 – based on quoted market prices in active markets for identical assets and liabilities;
 
Level 2 – based on quoted market prices for similar assets and liabilities, using observable market based inputs or unobservable market based inputs corroborated by market data; and
 
Level 3 – based on unobservable inputs using management’s best estimate and assumptions when inputs are unavailable.

The following tables present the fair value of our financial instruments measured at fair value on a recurring basis by level within the valuation hierarchy.
 
 
9

 
 
   
September 30, 2012
   
December 31, 2011
 
   
Level 1
   
Level 2
   
Total
   
Level 1
   
Level 2
   
Total
 
(In thousands)
                                   
Financial assets:
                                   
Money market funds
  $ 128,962     $ -     $ 128,962     $ 163,368     $ -     $ 163,368  
Certificate of deposit
    -       20,000       20,000       -       -       -  
Corporate debt securities
    -       23,772       23,772       -       44,877       44,877  
Commercial paper
    -       -       -       -       8,996       8,996  
U.S. government sponsored agency bonds
    2,004       -       2,004       2,015       -       2,015  
U.S. treasury securities
    2,001       -       2,001       5,513       -       5,513  
Foreign currency hedge contracts
    -       562       562       -       6,838       6,838  
Total
  $ 132,967     $ 44,334     $ 177,301     $ 170,896     $ 60,711     $ 231,607  
                                                 
Financial liabilities:
                                               
Foreign currency hedge contracts
  $ -     $ 4,446     $ 4,446     $ -     $ 9,783     $ 9,783  
 
The fair value of the certificate of deposit is priced using quoted market prices for similar instruments, non-binding market prices that are corroborated by observable market data. The certificate of deposit is restricted as it was purchased to collateralize the line of credit for Merus Labs International, Inc., see Note 6.

Corporate debt securities consist primarily of U.S. corporate bonds. The fair value of corporate debt securities is estimated using recently executed transactions or market quoted prices, where observable. Independent pricing sources are also used for valuation.
 
The fair value of commercial paper is estimated based on observable inputs of comparable securities.
 
The fair value of foreign currency hedging contracts is estimated based on pricing models using readily observable inputs from actively quoted markets and is disclosed on a gross basis.
 
The following tables present the fair value of assets and liabilities not subject to fair value recognition by level within the valuation hierarchy:
 
   
September 30, 2012
   
December 31, 2011
 
   
Carrying Value
   
Fair Value
Level 2
   
Fair Value
Level 3
   
Carrying Value
   
Fair Value
Level 2
   
Fair Value
Level 3
 
 (In thousands)
                                   
 Assets:
                                   
 Merus Labs Note Receivable
  $ 35,000     $ 34,999     $ -     $ -     $ -     $ -  
 Senior Secured Note Receivable
    9,922       9,813       -       -       -       -  
 Other Note Receivable
    1,750       -       1,750       -       -       -  
 Total
  $ 46,672     $ 44,812     $ 1,750     $ -     $ -     $ -  
                                                 
 Liabilities:
                                               
 Series 2012 Notes
  $ 164,065     $ 239,413     $ -     $ -     $ -     $ -  
 May 2015 Notes
    142,282       191,152       -       138,952       156,123       -  
 February 2015 Notes
    990       1,338       -       177,663       191,475       -  
 Non-recourse Notes
    -       -       -       93,370       95,237       -  
 Total
  $ 307,337     $ 431,903     $ -     $ 409,985     $ 442,835     $ -  
 
As of September 30, 2012, the fair values of our Merus Labs Note Receivable, our Senior Secured Note Receivable, and our Other Notes Receivable were determined using one or more discounted cash flow models, incorporating expected payments and the interest rate extended on the notes with fixed interest rates and incorporating expected payments for notes with a variable rate of return.

The fair values of our convertible notes and our Non-recourse Notes, as defined herein, were determined using quoted market pricing or dealer quotes of our then outstanding notes.
 
 
10

 


4. Cash Equivalents and Investments
 
As of September 30, 2012 and December 31, 2011, we had invested our excess cash balances primarily in money market funds, corporate debt securities, commercial paper, U.S. government sponsored agency bonds and U.S. treasury securities. Our securities are classified as available-for-sale and are carried at estimated fair value, with unrealized gains and losses, net of estimated taxes, reported in accumulated other comprehensive income (loss) in stockholders’ deficit. See Note 3 for fair value measurement information. The cost of securities sold is based on the specific identification method. To date, we have not experienced credit losses on investments in these instruments and we do not require collateral for our investment activities.

Summary of Available-For-Sale Securities
 
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Estimated Fair Value
 
(In thousands)
                       
September 30, 2012:
                       
Money market funds
  $ 128,962     $ -     $ -     $ 128,962  
Certificate of deposit
    20,000       -       -       20,000  
Corporate debt securities
    23,735       37       -       23,772  
U.S. government sponsored agency bonds
    2,001       3       -       2,004  
U.S. treasury securities
    1,999       2       -       2,001  
Total
  $ 176,697     $ 42     $ -     $ 176,739  
                                 
December 31, 2011:
                               
Money market funds
  $ 163,368     $ -     $ -     $ 163,368  
Corporate debt securities
    44,863       57       (43 )     44,877  
Commercial paper
    8,997       -       (1 )     8,996  
U.S. government sponsored agency bonds
    2,003       12       -       2,015  
U.S. treasury securities
    5,494       19       -       5,513  
Total
  $ 224,725     $ 88     $ (44 )   $ 224,769  
 
Classification on Condensed Consolidated Balance Sheets:
 
September 30,
2012
   
December 31,
2011
 
(In thousands)
           
Cash equivalents
  $ 128,962     $ 165,367  
Restricted investment
    20,000       -  
Short-term investments
    27,777       42,301  
Long-term investments
    -       17,101  
Total
  $ 176,739     $ 224,769  

Available-For-Sale Securities by Contractual Maturity
 
September 30, 2012
   
December 31, 2011
 
 (In thousands)
 
Amortized Cost
   
Fair Value
   
Amortized Cost
 
Fair Value
 
Less than one year
  $ 176,697     $ 176,739     $ 207,630     $ 207,668  
Greater than one year but less than five years
    -       -       17,095       17,101  
      Total
  $ 176,697     $ 176,739     $ 224,725     $ 224,769  
 
We recognized approximately $11,000 of gains on sales of available-for-sale securities for the three and nine months ended September 30, 2012. No gains or losses on sales of available-for-sale securities were recognized for the periods ended September 30, 2011. No significant facts or circumstances have arisen to indicate that there has been any deterioration in the creditworthiness of the issuers of these securities. Based on our review of these securities, we believe we had no other-than-temporary impairments on these securities as of September 30, 2012 and December 31, 2011.
 
 
11

 
 
5. Foreign Currency Hedging

We designate the foreign currency exchange contracts used to hedge our royalty revenues based on underlying Euro-denominated sales as cash flow hedges. Euro forward contracts are presented on a net basis on our Condensed Consolidated Balance Sheets as we have entered into a netting arrangement with the counterparty. As of September 30, 2012 and December 31, 2011, all outstanding Euro forward contracts and option contracts were classified as cash flow hedges.

In January 2012, we modified our existing Euro forward and option contracts related to our licensees’ sales through December 2012 into Euro forward contracts with more favorable rates. Additionally, we entered into a series of Euro forward contracts covering the quarters in which our licensees’ sales occur through December 2013.

During the third quarter of 2012, we reduced our forecasted exposure to the Euro for 2013 royalties. We de-designated and terminated certain forward contracts, due to our determination that certain cash flow under the de-designated contracts were probable to not occur, and recorded a gain of approximately $391,000 to other income, which was reclassified from other comprehensive income (loss) net of tax effects. The termination of these contracts was effected through a reduction in the notional amount of the original hedge contracts which was then exchanged for new hedges of 2014 Euro-denominated royalties. These 2014 hedges were entered into at a rate more favorable than the market rate as of the date of the exchange.
 
The notional amounts, Euro exchange rates, fair values of our Euro forward contracts at September 30, 2012, and Euro forward and option contracts at December 31, 2011, designated as cash flow hedges were:

Euro Forward Contracts
 
September 30, 2012
   
December 31, 2011
 
           
(In thousands)
   
(In thousands)
 
Currency
 
Settlement Price
($ per Euro)
 
Type
 
Notional Amount
   
Fair Value
   
Notional Amount
   
Fair Value
 
Euro
    1.400  
 Sell Euro
  $ -     $ -     $ 25,150     $ 1,837  
Euro
    1.200  
 Sell Euro
    -       -       117,941       (9,783 )
Euro
    1.230  
 Sell Euro
    55,246       (2,636 )     -       -  
Euro
    1.240  
 Sell Euro
    10,850       (462 )     -       -  
Euro
    1.270  
 Sell Euro
    44,450       (890 )     -       -  
Euro
    1.281  
 Sell Euro
    36,814       (458 )     -       -  
Euro
    1.300  
 Sell Euro
    91,000       562       -       -  
Total
            $ 238,360     $ (3,884 )   $ 143,091     $ (7,946 )
 
 
Euro Option Contracts
 
September 30, 2012
   
December 31, 2011
 
           
(In thousands)
   
(In thousands)
 
Currency
 
Strike Price
($ per Euro)
 
Type
 
Notional Amount
 
Fair Value
   
Notional Amount
 
Fair Value
 
Euro
    1.510  
 Purchased call option
  $ -     $ -     $ 27,126     $ -  
Euro
    1.315  
 Purchased call option
    -       -       129,244       5,001  
Total
            $ -     $ -     $ 156,370     $ 5,001  
 
The location and fair values of our Euro contracts in our Condensed Consolidated Balance Sheets were: 
 
Cash Flow Hedge
 
Location
 
September 30, 2012
   
December 31, 2011
 
(In thousands)
               
Euro contracts
 
Prepaid and other current assets
  $ 476     $ 1,837  
Euro contracts
 
Other assets
  $ 86     $ -  
Euro contracts
 
Accrued liabilities
  $ 2,636     $ 4,134  
Euro contracts
 
Other long-term liabilities
  $ 1,810     $ 648  
 
 
12

 
 
The effect of our derivative instruments in our Condensed Consolidated Statements of Income and our Condensed Consolidated Statements of Comprehensive Income were:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
(In thousands)
                       
Net gain (loss) recognized in OCI, net of tax (1)
  $ (3,454 )   $ 3,841     $ (1,851 )   $ (4,835 )
Gain (loss) reclassified from accumulated OCI into royalty revenue, net of tax (2)
  $ (328 )   $ (440 )   $ (998 )   $ 146  
Net loss recognized in interest and other income, net -- cash flow hedges (3)
  $ (27 )   $ -     $ (54 )   $ (19 )
Net gain recognized in interest and other income, net -- non-designated contracts (4)
  $ 391     $ -     $ 391     $ -  
Amount excluded from effectiveness testing
  $ -     $ -     $ -     $ -  
 
(1) Net change in the fair value of the effective portion of cash flow hedges classified in other comprehensive income (loss) (OCI)
(2) Effective portion classified as royalty revenue
(3) Ineffective portion classified as interest and other income, net
(4) Gain on de-designation classified as interest and other income, net
 
6. Notes and Other Long-term Receivables

Notes and other long-term receivables included the following significant agreements:

Merus Labs Note Receivable and Credit Agreement

In July 2012, PDL loaned $35.0 million to Merus Labs International, Inc. (Merus Labs) in connection with its acquisition of a commercial-stage pharmaceutical product and related assets (the Assets). In addition, PDL agreed to provide a $20.0 million letter of credit on behalf of Merus Labs that the seller of the Assets may draw upon to satisfy the remaining $20.0 million purchase price obligation on July 11, 2013 (Letter of Credit). The Letter of Credit is collateralized by a certificate of deposit reflected on our balance sheet as restricted investment. Draws on the Letter of Credit will be funded from the proceeds of an additional loan to Merus Labs. Outstanding borrowings under the July 2012 loan to Merus Labs bear interest at the rate of 13.5% per annum and outstanding borrowings as a result of draws on the Letter of Credit bear interest at the rate of 14.0% per annum, with all interest payable monthly. Merus Labs is required to make annual principal payments of $5.0 million, $7.5 million, $10.0 million, and $12.5 million in 2012, 2013, 2014, and 2015, respectively, with respect of the July 2012 loan. The borrowings are subject to mandatory prepayments upon certain asset dispositions or debt issuances upon the terms set forth in the credit agreement (Credit Agreement).

The Credit Agreement provides for a number of standard events of default, including payment, bankruptcy, covenant, judgment and cross-defaults.

Senior Secured Note Receivable

In March 2012, the Company executed a $7.5 million two-year senior secured note receivable (Senior Secured Note Receivable). In addition to interest, the note gives PDL certain rights to negotiate for certain royalty assets. The note was recorded net of origination fees that are accreted to the note receivable as interest income using the interest method. The note bore interest at 10% per annum, with interest due semi-annually and final interest due at maturity together with the principal.

In August 2012, PDL and the Borrower amended the note receivable, providing a senior secured note receivable of $10.0 million to replace the original $7.5 million note. The principal of the note receivable will be repaid on March 21, 2014.  Interest will be paid on the $10.0 million note receivable at a rate of 12% per annum with interest payments due semi-annually in March and September, and final interest due at maturity together with the principal. The note was recorded net of origination fees that are accreted to the note receivable as interest income using the interest method. The Company has not assigned a risk grade to the receivable or recorded an allowance for credit loss as PDL anticipates all payments will be received in full when due. No impairment has been recorded as the payments on the note are current.

For fair value information related to our notes and other long-term receivables, see Note 3.
 
 
13

 
 
 7. Accrued Liabilities
 
Accrued liabilities consisted of the following:

   
September 30,
2012
   
December 31,
2011
 
(In thousands)
           
Compensation
  $ 1,872     $ 1,341  
Interest payable
    3,087       3,351  
Deferred revenue
    -       1,713  
Foreign currency hedge
    2,636       4,134  
Dividend payable
    21,109       52  
Other
    2,779       1,018  
Total
  $ 31,483     $ 11,609  

8. Commitments and Contingencies
 
Legal Proceedings
 
Communications with Genentech regarding European SPCs
 
In August 2010, we received a letter from Genentech, sent on behalf of F. Hoffmann-LaRoche Ltd. (Roche) and Novartis AG (Novartis), asserting that Avastin, Herceptin, Lucentis and Xolair ® (the Genentech Products) do not infringe the supplementary protection certificates (SPCs) granted to PDL by various countries in Europe for each of the Genentech Products and seeking a response from PDL to these assertions. Genentech did not state what actions, if any, it intends to take with respect to its assertions. PDL’s SPCs were granted by the relevant national patent offices in Europe and specifically cover the Genentech Products. The SPCs covering the Genentech Products effectively extend our European patent protection for our European Patent No. 0 451 216B generally until December 2014, except that the SPCs for Herceptin will generally expire in July 2014.
 
Genentech’s letter does not suggest that the Genentech Products do not infringe PDL’s U.S. patents to the extent that such Genentech Products are made, used or sold in the United States (U.S.-based Sales). Genentech’s quarterly royalty payments received after receipt of the letter included royalties generated on all worldwide sales of the Genentech Products.
 
If Genentech is successful in asserting this position, then under the terms of our license agreements with Genentech, it would not owe us royalties on sales of the Genentech Products that are both manufactured and sold outside of the United States. Royalties on sale of the Genentech Products that are made and sold outside of the United States (ex-U.S.-based Manufacturing and Sales) accounted for approximately 35% of our royalty revenues for the nine months ended September 30, 2012. Based on announcements by Roche regarding moving more manufacturing outside of the United States, we expect this amount to increase in the future.
 
We believe that the SPCs are enforceable against the Genentech Products, that Genentech’s letter violates the terms of the 2003 settlement agreement and that Genentech owes us royalties on sales of the Genentech Products on a worldwide basis. We intend to vigorously assert our SPC-based patent rights.
 
Nevada Litigation with Genentech, Roche and Novartis in Nevada State Court
 
In August 2010, we filed a complaint in the Second Judicial District of Nevada, Washoe County, naming Genentech, Roche and Novartis as defendants. We intend to enforce our rights under our 2003 settlement agreement with Genentech and are seeking an order from the court declaring that Genentech is obligated to pay royalties to us on ex-U.S.-based Manufacturing and Sales of the Genentech Products.
 
The 2003 settlement agreement was entered into as part of a definitive agreement resolving intellectual property disputes between the two companies at that time. The agreement limits Genentech’s ability to challenge infringement of our patent rights and waives Genentech’s right to challenge the validity of our patent rights. Certain breaches of the 2003 settlement agreement as alleged by our complaint require Genentech to pay us liquidated and other damages of potentially greater than one billion dollars. This amount includes a retroactive royalty rate of 3.75% on past U.S.-based Sales of the Genentech Products and interest, among other items. We may also be entitled to either terminate our license agreements with Genentech or be paid a flat royalty of 3.75% on future U.S.-based Sales of the Genentech Products.
 
 
14

 
 
In November 2010, Genentech and Roche filed a motion to dismiss our complaint against them in which we seek to enforce our rights under the 2003 settlement agreement with Genentech. Genentech and Roche's motions to dismiss under Nevada Rule of Civil Procedure 12(b)(5) alleged that all of our claims for relief relating to the 2003 settlement agreement should be dismissed because the 2003 settlement agreement applies only to our U.S. patents. In addition, Roche filed a separate motion to dismiss our complaint under Nevada Rule of Civil Procedure 12(b)(2) on the ground that the Nevada court lacks personal jurisdiction over Roche. On July 7, 2011, the Second Judicial District Court of Nevada ruled in favor of us on the two motions to dismiss filed by Genentech and Roche. The court denied Genentech and Roche's motion to dismiss four of our five claims for relief and, further, denied Roche's separate motion to dismiss for lack of personal jurisdiction. The court dismissed one of our claims that Genentech committed a bad-faith breach of the covenant of good faith and fair dealing stating that, based on the current state of the pleadings, no "special relationship" had been established between Genentech and us as required under Nevada law. On November 1, 2011, the Nevada court issued an order accepting Roche’s stipulation of waiver to its personal jurisdiction defense. As a result of the order, Roche is foreclosed from reliance on lack of personal jurisdiction in defending against our claims.
 
On February 25, 2011, we reached a settlement with Novartis under which, among other things, we agreed to dismiss our claims against Novartis in the action in Nevada state court against Genentech, Roche and Novartis. Genentech and Roche continue to be parties to the Nevada suit.
 
The court has scheduled trial to commence on October 7, 2013, however this date is likely to be extended. The outcome of this litigation is uncertain and we may not be successful in our allegations.
 
Lease Guarantee
 
In connection with the spin-off of Facet Biotech Corporation (Facet) in 2008, we entered into amendments to the leases for our former facilities in Redwood City, California, under which Facet was added as a co-tenant under the leases, and a Co-Tenancy Agreement, under which Facet agreed to indemnify us for all matters related to the leases attributable to the period after the spin-off date. Should Facet default under its lease obligations, we would be held liable by the landlord as a co-tenant and, thus, we have in substance guaranteed the payments under the lease agreements for the Redwood City facilities. As of September 30, 2012, the total lease payments for the duration of the guarantee, which runs through December 2021, are approximately $103.0 million. We would also be responsible for lease-related costs including utilities, property taxes and common area maintenance which may be as much as the actual lease payments if Facet were to default. In April 2010, Abbott Laboratories acquired Facet and later renamed the company Abbott Biotherapeutics Corp.
 
As of September 30, 2012, and December 31, 2011, we had a liability of $10.7 million on our Condensed Consolidated Balance Sheets for the estimated fair value of this guarantee. In future periods, we may increase the recorded liability for this obligation if we conclude that a loss, which is larger than the amount recorded, is both probable and estimable.
 
9. Convertible Notes and Non-recourse Notes
  
       
Principal Balance Outstanding
   
Carrying Value
 
Description
 
Maturity Date
 
  September 30,
2012
   
September 30,
2012
   
December 31,
2011
 
(In thousands)
                     
Convertible Notes
                     
Series 2012 Notes
 
February 15, 2015
  $ 179,000     $ 164,065     $ -  
May 2015 Notes
 
May 1, 2015
  $ 155,250       142,282       138,952  
February 2015 Notes
 
February 15, 2015
  $ 1,000       990       177,663  
Non-recourse Notes
 
September 15, 2012
  $ -       -       93,370  
Total
              $ 307,337     $ 409,985  

 As of September 30, 2012, PDL was in compliance with all applicable debt covenants, and embedded features of all debt agreements were evaluated and did not need to be accounted for separately. For fair value information on our convertible notes and Non-recourse Notes, see Note 3.
 
Series 2012 Notes
 
In January 2012, we exchanged $169.0 million aggregate principal of new Series 2012 Notes for an identical principal amount of our February 2015 Notes, plus a cash payment of $5.00 for each $1,000 principal amount tendered, totaling approximately $845,000. The cash incentive payment was allocated to deferred issue costs of $765,000, additional paid-in capital of $52,000 and deferred tax assets of $28,000. The deferred issue costs will be recognized over the life of the Series 2012 Notes as interest expense. In February 2012, we entered into separate privately negotiated exchange agreements under which we exchanged an additional $10.0 million aggregate principal amount of the new Series 2012 Notes for an identical principal amount of our February 2015 Notes. At the conclusion of these transactions, $1.0 million of our February 2015 Notes remained outstanding.
 
 
15

 
 
The terms of the Series 2012 Notes are governed by the indenture dated as of January 5, 2012 (Indenture) and include a net share settlement feature, meaning that if a conversion occurs, the principal amount will be settled in cash and the excess, if any, will be settled in the Company’s common stock. The Series 2012 Notes may not be redeemed by the Company prior to their stated maturity date. Our Series 2012 Notes are due February 15, 2015 and bear interest at a rate of 2.875% per annum, payable semi-annually in arrears on February 15 and August 15 of each year. This is the same interest rate that we pay on the February 2015 Notes.
 
The initial conversion rate of the Series 2012 Notes was 155.396 shares of common stock per $1,000 principal amount, or approximately $6.44 per common share, subject to further adjustment upon certain events including dividend payments. Third party transaction costs of approximately $813,000 related to the exchange transactions have been recognized within general and administrative expense, of which $216,000 was recognized in the first quarter of 2012 and $597,000 was recognized during the year ended December 31, 2011.
 
Holders may convert their Series 2012 Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the stated maturity date of the Series 2012 Notes under the following circumstances:
 
 
·
During any fiscal quarter commencing after the fiscal quarter ending December 31, 2011, if the closing price of the Company’s common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter exceeds 130% of the conversion price for the Series 2012 Notes on the last day of such preceding fiscal quarter;
 
 
·
During the five business-day period immediately after any five consecutive trading-day period in which the trading price per $1,000 principal amount of the Series 2012 Notes for each trading day of that measurement period was less than 98% of the product of the closing price of the Company’s common stock and the conversion rate for the Series 2012 Notes for that trading day;
 
 
·
Upon the occurrence of certain corporate transactions as provided in the Indenture; or
 
 
·
Anytime, at the holder’s option, beginning on August 15, 2014.
  
Holders of our Series 2012 Notes who convert their Series 2012 Notes in connection with a fundamental change resulting in the reclassification, conversion, exchange or cancellation of our common stock may be entitled to a make-whole premium in the form of an increase in the conversion rate. Such fundamental change is generally defined to include a merger involving PDL, an acquisition of a majority of PDL’s outstanding common stock and a change of a majority of PDL’s board of directors without the approval of the board of directors.
 
We allocated $2.3 million of the remaining deferred February 2015 Notes original issue discount as of the date of the exchange to the Series 2012 Notes based on the percentage of the February 2015 Notes exchanged. In accordance with the accounting guidance for convertible debt instruments that may be settled in cash or other assets on conversion, we were required to separately account for the liability component of the instrument in a manner that reflects the market interest rate for a similar nonconvertible instrument at the date of issuance. As a result, we separated the principal balance of the Series 2012 Notes, net of the allocated original issue discount, between the fair value of the debt component and the common stock conversion feature. Using an assumed borrowing rate of 7.3%, which represents the estimated market interest rate for a similar nonconvertible instrument available to us during the period of the exchange transactions, we recorded a total debt discount of $16.8 million, allocated $10.9 million to additional paid-in capital and $5.9 million to deferred tax liability. The discount is being amortized to interest expense over the term of the Series 2012 Notes and increases interest expense during the term of the Series 2012 Notes from the 2.875% cash coupon interest rate to an effective interest rate of 7.3%. The common stock conversion feature is recorded as a component of stockholders’ deficit.
 
The principal amount, carrying value and unamortized discount of our Series 2012 Notes were:
 
   
September 30,
2012
   
December 31,
2011
 
(In thousands)
           
Principal amount of the Series 2012 Notes
  $ 179,000     $ -  
Unamortized discount of liability component
    (14,935 )     -  
Net carrying value of the Series 2012 Notes
  $ 164,065     $ -  
 
 
16

 
 
Interest expense for our Series 2012 Notes on the Condensed Consolidated Statements of Income was:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
(In thousands)
                       
Contractual coupon interest
  $ 1,287     $ -     $ 3,836     $ -  
Amortization of debt issuance costs
    279       -       826       -  
Amortization of debt discount
    1,439       -       4,219       -  
Total
  $ 3,005     $ -     $ 8,881     $ -  

As of September 30, 2012, our Series 2012 Notes are convertible into 166.264 shares of the Company’s common stock per $1,000 of principal amount, or approximately $6.01 per common share, subject to further adjustment upon certain events including dividend payments. As of September 30, 2012, the remaining discount amortization period was 2.4 years.
 
Our common stock price did not exceed the conversion threshold price of $7.98 per common share for at least 20 days during the 30 consecutive trading days ended June 30, 2012; accordingly the Series 2012 Notes were not convertible at the option of the holder during the quarter ended September 30, 2012. Our common stock did not exceed the conversion threshold price of $7.82 for at least 20 days during 30 consecutive trading days ended September 30, 2012; accordingly the Series 2012 Notes are not convertible at the option of the holder during the quarter ending December 31, 2012. At September 30, 2012, the if-converted value of our Series 2012 Notes exceeded their principal amount by approximately $50.2 million.
 
May 2015 Notes
 
As of September 30, 2012, our May 2015 Notes are convertible into 145.4893 shares of the Company’s common stock per $1,000 of principal amount, or approximately $6.87 per common share, subject to further adjustment upon certain events including dividend payments. If a conversion occurs, to the extent that the conversion value exceeds the principal amount, the principal amount is due in cash and the difference between the conversion value and the principal amount is due in shares of the Company’s common stock. As of September 30, 2012, the remaining discount amortization period was 2.6 years.
   
The principal amount, carrying value and unamortized discount of our May 2015 Notes were:
 
   
September 30,
2012
   
December 31,
2011
 
(In thousands)
           
Principal amount of the May 2015 Notes
  $ 155,250     $ 155,250  
Unamortized discount of liability component
    (12,968 )     (16,298 )
Net carrying value of the May 2015 Notes
  $ 142,282     $ 138,952  

Interest expense for our May 2015 Notes on the Condensed Consolidated Statements of Income was:
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2012
   
2011
   
2012
   
2011
 
(In thousands)
                       
Contractual coupon interest
  $ 1,455     $ 1,455     $ 4,366     $ 2,183  
Amortization of debt issuance costs
    299       290       891       434  
Amortization of debt discount
    1,130       1,051       3,330       1,570  
Total
  $ 2,884     $ 2,796     $ 8,587     $ 4,187  
 
Our common stock price did not exceed the conversion threshold price of $9.12 per common share for at least 20 days during the 30 consecutive trading days ended June 30, 2012; accordingly the May 2015 Notes were not convertible at the option of the holder during the quarter ended September 30, 2012. Our common stock did not exceed the conversion threshold price of $8.94 for at least 20 days during 30 consecutive trading days ended September 30, 2012; accordingly the May 2015 Notes are not convertible at the option of the holder during the quarter ending December 31, 2012. At September 30, 2012, the if-converted value of our May 2015 Notes exceeded their principal amount by approximately $18.7 million.
 
 
17

 
 
Purchased Call Options
 
At September 30, 2012, the purchased call options cover, subject to anti-dilution and certain other customary adjustments substantially similar to those in our May 2015 Notes, approximately 22.6 million shares of our common stock at a strike price of approximately $6.87, which corresponds to the conversion price of our May 2015 Notes. We may exercise the purchased call options upon conversion of our May 2015 Notes and require the hedge counterparty to deliver shares to the Company in an amount equal to the shares required to be delivered by the Company to the note holder for the excess conversion value.
 
Warrants
 
At September 30, 2012, the outstanding warrants of up to 27.5 million shares of common stock underlying our May 2015 Notes, had a strike price of approximately $8.09 per share, subject to additional anti-dilution and certain other customary adjustments.  
 
February 2015 Notes
 
As of September 30, 2012, our February 2015 Notes aggregate principal amount outstanding was $1.0 million, and were convertible into 166.264 shares of common stock per $1,000 principal amount or approximately $6.01 per common share. As of September 30, 2012, the remaining unamortized issuance costs of approximately $14,000 and the unamortized discount of approximately $10,000 are being amortized to interest expense over the term of our February 2015 Notes, with a remaining amortization period of approximately 2.4 years.
 
Non-recourse Notes
 
As of September 30, 2012, there was no remaining balance on our Non-recourse Notes, as they were fully repaid on September 17, 2012.
   
10. Other Long-Term Liabilities
 
Other long-term liabilities consisted of the following:
 
   
September 30,
2012
   
December 31,
2011
 
(In thousands)
           
Accrued lease liability
  $ 10,700     $ 10,700  
Uncertain tax position
    12,858       12,774  
Compensation
    379       -  
Foreign currency hedge
    1,810       648  
Total
  $ 25,747     $ 24,122  
 
11. Stock-Based Compensation
 
The Company grants stock options and restricted stock awards pursuant to a stockholder approved stock-based incentive plan. This incentive plan is described in further detail in Note 14, Stock-Based Compensation, of Notes to Consolidated Financial Statements in the 2011 Form 10-K.
 
 
18

 

There were no stock-based incentive grants during the three months ended September 30, 2012.  The following table summarizes the Company’s stock option and restricted stock award activity during the nine months ended September 30, 2012:

         
Stock Options
   
Restricted Stock Awards
 
(In thousands except per share amounts)
 
Shares Available for Grant
   
Number of Shares
   
Weighted Average Exercise Price
   
Number of Shares
   
Weighted Average Grant-date Fair Value Per Share
 
Balance December 31, 2011
    4,710       231     $ 16.62       137     $ 6.09  
Granted
    (117 )     -               117     $ 6.30  
Shares released
    -       -               (44 )   $ 6.73  
Forfeited or cancelled
    2       (35 )   $ 18.83       (2 )   $ 6.22  
Balance at September 30, 2012
    4,595       196     $ 16.22       208     $ 6.26  
 
 
12. Cash Dividends
 
On January 18, 2012, our board of directors declared that the regular quarterly dividends to be paid to our stockholders in 2012 will be $0.15 per share of common stock, payable on March 14, June 14, September 14 and December 14 of 2012 to stockholders of record on March 7, June 7, September 7 and December 7 of 2012, the record dates for each of the dividend payments, respectively.
 
In connection with the September 14, 2012, dividend payment, the conversion rates for our convertible notes adjusted as follows:
 
Convertible Notes
 
Conversion Rate per $1,000 Principal Amount
   
Approximate Conversion Price Per Common Share
 
Effective Date
Series 2012 Notes
    166.26     $ 6.01  
September 5, 2012
May 2015 Notes
    145.49     $ 6.87  
September 5, 2012
February 2015 Notes
    166.26     $ 6.01  
September 10, 2012
 
13. Income Taxes
 
For the three and nine months ended September 30, 2012 and 2011, income tax expense was primarily derived by applying the federal statutory rate of 35% to operating income before income taxes.
 
In general, our income tax returns are subject to examination by tax authorities for tax years 1995 forward. In May 2012, PDL received a “no-change” letter from the Internal Revenue Service (IRS) upon completion of an examination of the Company’s 2008 Federal tax return. The California Franchise Tax Board (FTB) is currently examining the Company’s 2008 and 2009 tax returns. Although the timing of the resolution of income tax examinations is highly uncertain, and the amounts ultimately paid, if any, upon resolution of the issues raised by the taxing authorities may differ materially from the amounts accrued for each year, we do not anticipate any material change to the amount of our unrecognized tax benefits over the next 12 months.
 
14. Accumulated Other Comprehensive Income (Loss)
 
Comprehensive income comprises net income and other comprehensive income (loss). We include unrealized net gains on investments held in our available-for-sale securities and unrealized gains (losses) on our cash flow hedges in other comprehensive income (loss), and present the amounts net of tax. Our other comprehensive income (loss) is included in our Condensed Consolidated Statements of Comprehensive Income.

The balance of accumulated other comprehensive income (loss), net of tax, was as follows:
 
   
Unrealized gains (losses) on available-for-sale securities
   
Unrealized losses on cash flow hedges
   
Total Accumulated Other Comprehensive Loss
 
(In thousands)
                 
Beginning Balance at December 31, 2011
  $ 29     $ (1,914 )   $ (1,885 )
Activity for the nine months ended September 30, 2012
    (1 )     (853 )     (854 )
Ending Balance at September 30, 2012
  $ 28     $ (2,767 )   $ (2,739 )

 
19

 
 
15. Subsequent Events
 
Revenue Interest Purchase Agreement
 
In October 2012, PDL entered into a Revenue Interests Purchase Agreement (Royalty Agreement) with AxoGen, Inc. (AxoGen), pursuant to which PDL will receive specified royalties on AxoGen’s Net Revenues (as defined in the Royalty Agreement) generated by the sale, distribution or other use of AxoGen’s products. The Royalty Agreement has an eight year term, and provides PDL with high single digit royalties based on AxoGen’s Net Revenues, subject to agreed-upon minimum payments as provided by the Royalty Agreement beginning in the fourth quarter of 2014, and the right to require AxoGen to repurchase the revenue contract at the end of the fourth year. AxoGen has been granted certain rights to call the revenue contract in years five through eight. The total consideration PDL paid to AxoGen for the royalty rights was $20.8 million, including the termination of an interim funding of $1.8 million in August 2012. AxoGen was required to use a portion of the proceeds from the Royalty Agreement to pay the outstanding balance under its existing credit facility. AxoGen plans to use the remainder of the proceeds to support the business plan for its products. The royalty rights are secured by the cash and accounts receivable of AxoGen.
 
Credit Agreement

In November 2012, PDL loaned to Wellstat Diagnostics, LLC (Wellstat) pursuant to a Credit Agreement (Credit Agreement) $40 million to be used by Wellstat in connection with its development and commercialization of small point of care diagnostic systems that can perform a wide variety of tests targeting the clinical diagnostics market. Of the $40 million borrowed, Wellstat Diagnostics will use approximately $11.6 million to repay an existing credit facility between PDL and the holders of Wellstat’s equity interests.

Outstanding principal under the Credit Agreement bears interest at the rate of 5.0% per annum, payable quarterly in arrears, in cash or paid-in-kind notes that add to the principal balance.  The Credit Agreement matures at its latest on December 31, 2021.  Wellstat is required to repay the outstanding principal and a specific target internal rate of return amount to PDL at maturity or upon the occurrence of certain key events such as a sale of Wellstat Diagnostics or substantially all of its assets or if Wellstat Diagnostics misses a specified revenue target for fiscal year 2017.  The loan will be considered repaid at any time the aggregate amount of all payments made by Wellstat to PDL, including interest and any royalty payments, equals specified target internal rates of return set forth in the Credit Agreement.  The target internal rates of return depend on whether the date of repayment is on or after December 31, 2014, and is higher after December 31, 2014. Upon commercialization of Wellstat's diagnostic systems, PDL will receive a low double digit royalty on Wellstat Diagnostics' net revenues.

The Credit Agreement is secured by a pledge of substantially all of the assets of Wellstat and a pledge of all of Wellstat’s equity interests by the holders thereof.
   
 
20

 

ITEM 2.             MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
This Quarterly Report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts are “forward-looking statements” for purposes of these provisions, including any projections of earnings, revenues or other financial items, any statements of the plans and objectives of management for future operations, including any statements concerning new licensing, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “intends,” “plans,” “believes,” “anticipates,” “expects,” “estimates,” “predicts,” “potential,” “continue” or “opportunity,” or the negative thereof or other comparable terminology. Although we believe that the expectations presented in the forward-looking statements contained herein are reasonable at the time they were made, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including but not limited to the risk factors set forth below or incorporated by reference herein, and for the reasons described elsewhere in this Quarterly Report. All forward-looking statements and reasons why results may differ included in this Quarterly Report are made as of the date hereof, and we assume no obligation to update these forward-looking statements or reasons why actual results might differ.
 
OVERVIEW
 
PDL pioneered the humanization of monoclonal antibodies and, by doing so, enabled the discovery of a new generation of targeted treatments for cancer and immunologic diseases. Today, PDL is focused on intellectual property asset management, investing in new revenue generating assets and maximizing the value of its patent portfolio and related assets. We receive royalties based on sales of humanized antibody products marketed today and may also receive royalty payments on additional humanized antibody products that are manufactured or launched before final patent expiry in December 2014 or which are otherwise subject to a royalty for licensed know-how under our agreements. Under most of our licensing agreements, we are entitled to receive a flat-rate or tiered royalty based upon our licensees’ net sales of covered antibodies.
 
We continuously evaluate alternatives to increase return for our stockholders, for example, purchasing new revenue generating assets, buying back or redeeming our convertible notes, repurchasing our common stock, paying dividends or selling the company. At the beginning of each fiscal year, our board of directors reviews the Company’s total annual dividend payment for the prior year and determines whether to increase, maintain or decrease the quarterly dividend payments for that year. The board of directors evaluates the financial condition of the Company and considers the economic outlook, corporate cash flow, the Company’s liquidity needs and the health and stability of credit markets when determining whether to maintain or change the dividend.
 
Recent Developments
 
September 14, 2012, Dividend Payment and Effect on Conversion Rates for the Convertible Notes
 
On January 18, 2012, our board of directors declared that the regular quarterly dividends to be paid to our stockholders in 2012 will be $0.15 per share of common stock, payable on March 14, June 14, September 14 and December 14 of 2012 to stockholders of record on March 7, June 7, September 7 and December 7 of 2012, the record dates for each of the dividend payments, respectively. On September 14, 2012, we paid the regular quarterly dividend to our stockholders totaling $21.0 million using earnings generated in the first nine months of 2012.

In connection with the September 14, 2012, dividend payment, the conversion rates for our convertible notes adjusted as follows:
 
Convertible Notes
 
Conversion Rate per $1,000 Principal Amount
   
Approximate Conversion Price Per Common Share
 
Effective Date
May 2015 Notes
    145.49     $ 6.87  
September 5, 2012
Series 2012 Notes
    166.26     $ 6.01  
September 5, 2012
February 2015 Notes
    166.26     $ 6.01  
September 10, 2012
                   

In connection with a cash dividend, the conversion rates increase based on multiplying the previous conversion rate by a fraction, calculated as follows:
 
 
·
for the May 2015 Notes, the numerator equals the average closing price of PDL's common stock for the ten consecutive trading days immediately preceding the ex-dividend date, and the denominator of which is such ten day average closing price less the per share dividend amount; and
 
 
·
for the Series 2012 Notes and February 2015 Notes, the numerator equals the average closing price of PDL's common stock for the five consecutive trading days immediately preceding the ex-dividend date, and the denominator of which is such five day average closing price less the per share dividend amount.
 
 
21

 
 
Merus Labs Note Receivable and Credit Agreement

In July 2012, PDL loaned $35.0 million to Merus Labs International, Inc. (Merus Labs) in connection with its acquisition of a commercial-stage pharmaceutical product and related assets (the Assets). In addition, PDL agreed to provide a $20.0 million letter of credit on behalf of Merus Labs that the seller of the Assets may draw upon to satisfy the remaining $20.0 million purchase price obligation on July 11, 2013 (Letter of Credit). The Letter of Credit is collateralized by a certificate of deposit reflected on our balance sheet as restricted investment. Draws on the Letter of Credit will be funded from the proceeds of an additional loan to Merus Labs. Outstanding borrowings under the July 2012 loan to Merus Labs bear interest at the rate of 13.5% per annum and outstanding borrowings as a result of draws on the Letter of Credit bear interest at the rate of 14.0% per annum, with all interest payable monthly. Merus Labs is required to make annual principal payments of $5.0 million, $7.5 million, $10.0 million, and $12.5 million in 2012, 2013, 2014, and 2015, respectively, in respect of the July 2012 loan. The borrowings are subject to mandatory prepayments upon certain asset dispositions or debt issuances upon the terms set forth in the credit agreement (Credit Agreement).

The Credit Agreement provides for a number of standard events of default, including payment, bankruptcy, covenant, judgment and cross-defaults.

Perjeta TM
 
On June 8, 2012, Genentech announced that the U.S. Food and Drug Administration (FDA) approved Perjeta (pertuzumab). Perjeta is approved in combination with Herceptin ® and docetaxel chemotherapy for the treatment of people with HER2-positive metastatic breast cancer who have not received prior anti-HER2 therapy or chemotherapy for metastatic disease.
 
Genentech notified PDL on June 18, 2012, that Perjeta is a licensed product. The third quarter royalty payment included royalties on second quarter sales of Perjeta in accordance with Genentech’s license agreements with PDL.
 
Subsequent Events
 
Revenue Interest Purchase Agreement
 
In October 2012, PDL entered into a Revenue Interests Purchase Agreement (Royalty Agreement) with AxoGen, Inc. (AxoGen) pursuant to which PDL will receive specified royalties on AxoGen’s Net Revenues (as defined in the Royalty Agreement) generated by the sale, distribution or other use of AxoGen’s products. The Royalty Agreement has an eight year term, and provides PDL with high single digit royalties based on AxoGen Net Revenues, subject to agreed-upon minimum payments as provided by the Royalty Agreement beginning in the fourth quarter of 2014, and the right to require AxoGen to repurchase the revenue contract at the end of the fourth year. AxoGen has been granted certain rights to call the revenue contract in years five through eight. The total consideration PDL paid to AxoGen for the royalty rights was $20.8 million, including the termination of an interim funding of $1.8 million in August 2012. AxoGen was required to use a portion of the proceeds from the Royalty Agreement to pay the outstanding balance under its existing credit facility. AxoGen plans to use the remainder of the proceeds to support the business plan for its products. The royalty rights are secured by the cash and accounts receivable of AxoGen.
 
Credit Agreement

In November 2012, PDL loaned to Wellstat Diagnostics, LLC (Wellstat) pursuant to a Credit Agreement (Credit Agreement) $40 million to be used by Wellstat in connection with its development and commercialization of small point of care diagnostic systems that can perform a wide variety of tests targeting the clinical diagnostics market. Of the $40 million borrowed, Wellstat Diagnostics will use approximately $11.6 million to repay an existing credit facility between PDL and the holders of Wellstat’s equity interests.

Outstanding principal under the Credit Agreement bears interest at the rate of 5.0% per annum, payable quarterly in arrears, in cash or paid-in-kind notes that add to the principal balance.  The Credit Agreement matures at its latest on December 31, 2021.  Wellstat is required to repay the outstanding principal and a specific target internal rate of return amount to PDL at maturity or upon the occurrence of certain key events such as a sale of Wellstat Diagnostics or substantially all of its assets or if Wellstat Diagnostics misses a specified revenue target for fiscal year 2017.  The loan will be considered repaid at any time the aggregate amount of all payments made by Wellstat to PDL, including interest and any royalty payments, equals specified target internal rates of return set forth in the Credit Agreement.  The target internal rates of return depend on whether the date of repayment is on or after December 31, 2014, and is higher after December 31, 2014. Upon commercialization of Wellstat's diagnostic systems, PDL will receive a low double digit royalty on Wellstat Diagnostics' net revenues.

The Credit Agreement is secured by a pledge of substantially all of the assets of Wellstat and a pledge of all of Wellstat’s equity interests by the holders thereof.
 
Intellectual Property
 
Patents
 
We have been issued patents in the United States and elsewhere, covering the humanization of antibodies, which we refer to as our Queen et al. patents. Our Queen et al. patents, for which final patent expiry is in December 2014, cover, among other things, humanized antibodies, methods for humanizing antibodies, polynucleotide encoding in humanized antibodies and methods of producing humanized antibodies.
 
 
22

 
   
The following is a list of our U.S. patents within our Queen et al. patent portfolio:
 
Application Number
 
Filing Date
 
Patent Number
 
Issue Date
 
Expiration Date
08/477,728
 
06/07/95
    5585089  
12/17/96
 
06/25/13
08/474,040
 
06/07/95
    5693761  
12/02/97
 
12/02/14
08/487,200
 
06/07/95
    5693762  
12/02/97
 
06/25/13
08/484,537
 
06/07/95
    6180370  
01/30/01
 
06/25/13

Our U.S. Patent No. 5,693,761 patent (‘761 patent), which is the last to expire of our U.S. patents, covers methods and materials used in the manufacture of humanized antibodies. In addition to covering methods and materials used in the manufacture of humanized antibodies, coverage under our ‘761 patent will typically extend to the use or sale of compositions made with those methods and/or materials.
 
The European Patent No. 0 451 216B (‘216B Patent) expired in Europe in December 2009. We have been granted Supplementary Protection Certificates (SPCs) for the Avastin ® , Herceptin, Lucentis ® , Xolair ® and Tysabri ® products in many of the jurisdictions in the European Union in connection with the ‘216B Patent. These SPCs effectively extend our patent protection with respect to these products generally until December 2014, except that most of our SPCs for Herceptin will expire in July 2014. Because SPCs are granted on a jurisdiction-by-jurisdiction basis, the duration of the extension varies slightly in certain jurisdictions. We may still be eligible for royalties notwithstanding the unavailability of SPC protection if the relevant royalty-bearing humanized antibody product is also made, used, sold or offered for sale in or imported from a jurisdiction in which we have an unexpired Queen et al. patent such as the United States.
 
Licensing Agreements
 
We have entered into licensing agreements with numerous entities that are independently developing or have developed humanized antibodies under which we have licensed certain rights under our Queen et al. patents to make, use, sell, offer for sale and import humanized antibodies. We receive royalties on net sales of products that are made, used or sold prior to patent expiry. In general, these agreements cover antibodies targeting antigens specified in the license agreements. Under our licensing agreements, we are entitled to receive a flat-rate or tiered royalty based upon our licensees’ net sales of covered antibodies. Additionally, we receive minimal annual maintenance fees, as well as periodic milestone payments, from licensees of our Queen et al. patents prior to patent expiry. Total annual milestone payments in each of the last several years have been less than one percent of total revenue and we expect this trend will continue through the expiration of the Queen et al. patents. Each of our licenses provides for certain audit rights with respect to royalty payments from our licensees, and we have established a regular process of routinely auditing our royalty paying licensees to ensure compliance with the payment provisions in our licenses with them.
 
Licensing Agreements for Marketed Products
 
In the nine months ended September 30, 2012, we received royalties on sales of the seven humanized antibody products listed below, all of which are currently approved for use by the FDA and other regulatory agencies outside the United States.
 
Licensee
 
Product Names
Genentech, Inc. (Genentech)
 
Avastin
   
Herceptin
   
Xolair
   
Lucentis
   
Perjeta
     
Elan Corporation, Plc (Elan)
 
Tysabri
     
Chugai Pharmaceutical Co., Ltd. (Chugai)
 
Actemra ®
     

For the three months ended September 30, 2012 and 2011, we received royalty revenues under license agreements of $85.2 million and $83.4 million, respectively, and for the nine months ended September 30, 2012 and 2011, we received royalty revenues under license agreements of $288.5 million and $278.8 million, respectively.
 
 
23

 
 
Genentech
 
We entered into a master patent license agreement, effective September 25, 1998, under which we granted Genentech a license under our Queen et al. patents to make, use and sell certain antibody products. Our master patent license agreement with Genentech provides for a tiered royalty structure under which the royalty rate Genentech must pay on royalty-bearing products sold in the United States or manufactured in the United States and used or sold anywhere in the world (U.S.-based Sales) in a given calendar year decreases on incremental U.S.-based Sales above certain sales thresholds based on 95% of the underlying gross U.S.-based Sales. The net sales thresholds and the applicable royalty rates are outlined below:
Genentech Products Made or Sold in the U.S.
 
Royalty Rate
 
Net sales up to $1.5 billion
    3.0 %
Net sales between $1.5 billion and $2.5 billion
    2.5 %
Net sales between $2.5 billion and $4.0 billion
    2.0 %
Net sales exceeding $4.0 billion
    1.0 %
         
Genentech Products Made and Sold ex-U.S.
       
Net sales
    3.0 %
 
As a result of the tiered royalty structure, Genentech’s average annual royalty rate for a given year will decline as Genentech’s U.S.-based Sales increase during that year. Because we receive royalties one quarter in arrears, the average royalty rates for the payments we receive from Genentech for U.S.-based Sales in the second calendar quarter for Genentech’s sales from the first calendar quarter have been and are expected to continue to be higher than the average royalty rates for following quarters. The average royalty rates for payments we receive from Genentech are generally lowest in the fourth and first calendar quarters for Genentech’s sales from the third and fourth calendar quarters when more of Genentech’s U.S.-based Sales bear royalties at the one percent royalty rate.
 
With respect to royalty-bearing products that are both manufactured and sold outside of the United States (ex-U.S.-based Manufacturing and Sales), the royalty rate that we receive from Genentech is a fixed rate of 3.0% based on 95% of the underlying gross ex-U.S.-based Manufacturing and Sales. The mix of U.S.-based Sales and ex-U.S.-based Manufacturing and Sales has fluctuated in the past and may continue to fluctuate in future periods, particularly in light of the 2009 acquisition of Genentech by Roche. The percentage of net global sales that were generated outside of the United States and the percentage of net global sales that were ex-U.S.-based Manufacturing and Sales are outlined in the following table:

Manufacturing Split
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Avastin
                       
Ex-U.S.-based Sales
    56 %     56 %     56 %     56 %
Ex-U.S.-based Manufacturing and Sales
    29 %     19 %     25 %     19 %
Herceptin
                               
Ex-U.S.-based Sales
    70 %     73 %     70 %     72 %
Ex-U.S.-based Manufacturing and Sales
    37 %     43 %     38 %     38 %
Lucentis
                               
Ex-U.S.-based Sales
    65 %     60 %     62 %     58 %
Ex-U.S.-based Manufacturing and Sales
    0 %     0 %     0 %     0 %
Xolair
                               
Ex-U.S.-based Sales
    39 %     41 %     39 %     40 %
Ex-U.S.-based Manufacturing and Sales
    39 %     41 %     39 %     40 %
 
The information in the table above is based on information provided to us by Genentech. We were not provided the reasons for the shift in the manufacturing split between U.S.-based Sales and ex-U.S.-based Manufacturing and Sales.
 
In the nine months ended September 30, 2012 and 2011, PDL received royalties generated from three of Genentech’s licensed products that were ex-U.S.-based manufactured and sold: Herceptin, Avastin and Xolair. Roche has announced that there are new plants in Singapore for the production of Avastin and Lucentis. Roche has also expanded its Penzberg, Germany plant that currently manufactures Herceptin. The master patent license agreement continues until the expiration of the last to expire of our Queen et al. patents but may be terminated (i) by Genentech prior to such expiration upon sixty days written notice, (ii) by either party upon a material breach by the other party or (iii) upon the occurrence of certain bankruptcy-related events. Our licensing agreements with Genentech entitle us to royalties following the expiration of our patents with respect to sales of products manufactured prior to patent expiry in jurisdictions providing patent protection.
 
 
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Elan
 
We entered into a patent license agreement, effective April 24, 1998, under which we granted to Elan a license under our Queen et al. patents to make, use and sell antibodies that bind to the cellular adhesion molecule a 4 in patients with multiple sclerosis. Under the agreement, we are entitled to receive a flat royalty rate in the low single digits based on Elan’s net sales of the Tysabri product. The agreement continues until the expiration of the last to expire of our Queen et al. patents but may be terminated (i) by Elan prior to such expiration upon sixty days written notice, (ii) by either party upon a material breach by the other party or (iii) upon the occurrence of certain bankruptcy-related events.
 
Chugai
 
We entered into a patent license agreement, effective May 18, 2000, with Chugai, a majority owned subsidiary of Roche, under which we granted to Chugai a license under our Queen et al. patents to make, use and sell antibodies that bind to interleukin-6 receptors to prevent inflammatory cascades involving multiple cell types for the treatment of rheumatoid arthritis. Under the agreement, we are entitled to receive a flat royalty rate in the low single digits based on net sales of the Actemra   product manufactured in the U.S. The agreement continues until the expiration of the last to expire of our Queen et al. patents but may be terminated (i) by Chugai prior to such expiration upon sixty days written notice, (ii) by either party upon a material breach by the other party or (iii) upon the occurrence of certain bankruptcy-related events.
 
Licensing Agreements for Non-Marketed Products
 
We have also entered into licensing agreements under which we have licensed certain rights under our Queen et al. patents to make, use and sell certain products that are not currently marketed. Certain of these development-stage products are currently in Phase 3 clinical trials. With respect to these agreements, we may receive payments based on certain development milestones and annual maintenance fees. We may also receive royalty payments if the licensed products receive marketing approval and are manufactured or generate sales before the expiration of our Queen et al. patents. For example, trastuzumab-DM1 (T-DM1) which is an experimental, antibody-drug conjugate that links Herceptin to a cytotoxic, or cell killing agent, DM1, is being developed by Genentech. This approach is designed to increase the already significant tumor fighting ability of Herceptin by coupling it with an additional cell killing agent that is efficiently and simultaneously delivered to the targeted cancer cells by the antibody. An additional example is the Eli Lilly and Company (Lilly) licensed antibody for the treatment of Alzheimer’s disease. Lilly has reported that both of its Phase 3 trials did not meet the primary endpoints of cognitive and functional benefits. A pre-specified secondary subgroup analysis of the pooled data from both Phase 3 trials showed that solanezumab slowed the cognitive decline in patients with mild disease but not patients with moderate disease. Lilly has said that it plans to discuss the data with regulatory authorities. If Lilly’s antibody for Alzheimer’s disease is approved, we would receive royalties on sales of solanezumab manufactured before patent expiration, as well as be entitled to receive a royalty based on a “know-how” license for technology provided in the design of this antibody. Unlike the royalty for the patent license, the two percent royalty payable for “know-how” runs for 12.5 years after the product’s initial commercialization.
   
Economic and Industry-wide Factors
 
Various economic and industry-wide factors are relevant to us and could affect our business, including changes to laws and interpretation of those laws that protect our intellectual property rights, our licensees ability to obtain or retain regulatory approval for products licensed under our patents, fluctuations in foreign currency exchange rates, the ability to attract, retain and integrate qualified personnel, as well as overall global economic conditions. We actively monitor economic, industry and market factors affecting our business, however, we cannot predict the impact such factors may have on our future results of operations, liquidity and cash flows. See also the “Risk Factors” section of this quarterly report for additional factors that may impact our business and results of operations.
 
Critical Accounting Policies and Uses of Estimates
 
During the nine months ended September 30, 2012, there have been no significant changes to our critical accounting policies since those presented in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2011, except for the foreign currency hedging presented below.

Foreign Currency Hedging

We hedge certain Euro-denominated currency exposures related to our licensees’ product sales with Euro forward contracts and option contracts. In general, these contracts are intended to offset the underlying Euro market risk in our royalty revenues. We do not enter into speculative transactions. We designate foreign currency exchange contracts used to hedge royalty revenues based on underlying Euro-denominated sales as cash flow hedges.
 
At the inception of the hedging relationship and on a quarterly basis, we assess hedge effectiveness. The fair value of the Euro forward contracts is estimated using pricing models with readily observable inputs from actively quoted markets and is disclosed on a gross basis. The aggregate unrealized gain or loss, net of tax, on the effective portion of the hedge is recorded in stockholders’ deficit as accumulated other comprehensive income (loss). Gains or losses on cash flow hedges are recognized as an adjustment to royalty revenue in the same period that the hedged transaction impacts earnings as royalty revenue. The hedge effectiveness is dependent upon the amounts of future royalties and, if future royalties based on the Euro are lower than forecasted, the amount of ineffectiveness would be reported in our Consolidated Statements of Income.
 
 
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During the third quarter of 2012, we de-designated and terminated a portion of our 2013 hedges, due to our determination that certain cash flow under the de-designated contracts were probable to not occur. The gain realized was reclassified from other comprehensive income (loss) to other income in the third quarter.
 
Operating Results
 
Three and nine months ended September 30, 2012, compared to three and nine months ended September 30, 2011

Revenues

   
Three Months Ended
September 30,
   
Change from Prior
   
Nine Months Ended
September 30,
   
Change from Prior
 
   
2012
   
2011
    Year %    
2012
   
2011
    Year %  
(Dollars in thousands)
                                   
Revenues
                                   
Royalties
  $ 85,231     $ 83,370       2 %   $ 288,479     $ 278,833       3 %
License and other
    -       400       -100 %     -       10,400       -100 %
Total revenues
  $ 85,231     $ 83,770       2 %   $ 288,479     $ 289,233       0 %
 
Total royalty revenues were $85.2 million and $83.4 million for the three months ended September 30, 2012 and 2011, respectively, and consisted of royalties and maintenance fees earned on sales of products under license agreements associated with our Queen et al. patents. Royalty revenue is net of the payments made under our February 2011 settlement agreement with Novartis, which is based on a portion of the royalties that the company receives from Lucentis sales made by Novartis outside the United States. The amount paid is less than we receive in royalties on such sales.

Royalty revenues increased two percent for the three months ended September 30, 2012, when compared to the same period in 2011. The growth is primarily driven by increased royalties in the second quarter of 2012 of Avastin, Lucentis and Xolair by our licensees. Net sales of Avastin, Herceptin, Lucentis, Xolair and Perjeta, are subject to a tiered royalty rate except in the case when the product is ex-U.S. Manufactured and Sold, in which case it is subject to a flat three percent royalty rate.

Total revenues were $288.5 million and $289.2 million for the nine months ended September 30, 2012 and 2011, respectively, and consist of royalty revenues as well as license and other revenues including, for the nine months ended September 30, 2011, a one-time $10.0 million payment from our legal settlement with UCB Pharma, S.A. (UCB) resolving all legal disputes between the two companies, including those relating the UCB’s pegylated humanized antibody fragment, Cimzia ® , and PDL’s patents known as the Queen et al. patents.
 
The following table summarizes the percentage of our total revenues earned from our licensees’ net product sales, which individually accounted for ten percent or more of our total revenues:
 
       
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
Licensee
 
Product Name
 
2012
   
2011
   
2012
   
2011
 
Genentech
 
Avastin
    30 %     28 %     31 %     30 %
   
Herceptin
    36 %     38 %     35 %     34 %
   
Lucentis
    15 %     15 %     18 %     16 %
                                     
Elan
 
Tysabri
    14 %     14 %     12 %     11 %

Foreign currency exchange rates also impact our revenue results. More than 50% of our licensees’ product sales are in currencies other than U.S. dollars; as such, our revenues may fluctuate due to changes in foreign currency exchange rates and are subject to foreign currency exchange risk. While foreign currency conversion terms vary by license agreement, generally most agreements require that royalties first be calculated in the currency of sale and then converted into U.S. dollars using the average daily exchange rates for that currency for a specified period at the end of the calendar quarter. Accordingly, when the U.S. dollar weakens against other currencies, the converted amount is greater than it would have been had the U.S. dollar not weakened. For example, in a quarter in which we generate $70 million in royalty revenues, approximately $35 million is based on sales in currencies other than U.S. dollar. If the U.S. dollar strengthens across all currencies by ten percent during the conversion period for that quarter, when compared to the same amount of local currency royalties for the prior year, U.S. dollar converted royalties will be approximately $3.5 million less in the current quarter than in the prior year quarter. The impact on full year revenue is greatest in the second quarter when we receive the largest amount of royalties because the Genentech tiered royalties are at their highest rate for first quarter sales.
 
 
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As a result of our Euro forward contracts, royalty revenues recognized decreased $0.5 million and $0.7 million, for the three months ended September 30, 2012 and 2011, respectively, and for the nine months ended September 30, 2012 and 2011, royalty revenues recognized increased (decreased) $(1.5) million and $0.2 million, respectively.
 
Operating Expenses
 
   
Three Months Ended
September 30,
   
Change from Prior
   
Nine Months Ended
September 30,
   
Change from Prior
 
   
2012
   
2011
    Year %    
2012
   
2011
    Year %  
(In thousands)
                                   
Operating expenses
                                   
General and administrative
  $ 5,647     $ 3,