**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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FORM 10-K

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| **(Mark one)**                                                                                                                                                                                                                                                                                                                                 |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                                                                                                                                                          | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the Fiscal Year Ended December 31, 2004  or**                                                                                                                                                                                                                                                                                       |
| **o**                                                                                                                                                                                                                                                                                                                                          | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the transition period from                           to                          ** |

 

**CommissionFile Number 000-30231**

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**TANOX, INC.**

(Exact name of registrantas specified in its charter)
| **Delaware**                    | ** ** | **76-0196733**       |
|---------------------------------|------------|----------------------|
| (State or other jurisdiction of |       | (I.R.S. Employer     |
| incorporation or organization)  |       | Identification  No.) |

 

**10301 Stella Link, Houston,Texas 77025**

(Address of principalexecutive offices)

**713-578-4000**

(Registrant’s telephonenumber, including area code)

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Securities Registered Pursuantto Section 12(b) of the Act:  **None**

Securities RegisteredPursuant to Section 12(g) of the Act: **Common Stock, $.01 par value**

**Preferred SharePurchase Rights**

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x   Noo

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act). Yes x   Noo

The aggregate market value of the registrant’s commonstock held by nonaffiliates as of June 30, 2004 was $582,931,932.

Number of shares of outstanding common stock as of March 2,2005:  44,000,398.

**DOCUMENTSINCORPORATED BY REFERENCE**

The information called forby Items 10, 11, 12 and 13 of Part III will be included in the registrant’sdefinitive proxy statement to be filed pursuant to Regulation 14A and isincorporated herein by reference.

 

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**TABLE OF CONTENTS**
|            | ** ** | **PART I**                                                                             | ** ** | **Page** |
|------------|------------|---------------------------------------------------------------------------------------------|------------|----------|
| ITEM 1.    |       | Business                                                                                    |       | 1        |
| ITEM 2.    |       | Properties                                                                                  |       | 27       |
| ITEM 3.    |       | Legal Proceedings                                                                           |       | 27       |
| ITEM  4.   |       | Submission of Matters to  a Vote of Security Holders                                        |       | 27       |
| ** ** |       | **PART II**                                                                            |       |     |
| ITEM  5.   |       | Market for the Company’s  Common Equity and Related Stockholder Matters                |       | 28       |
| ITEM 6.    |       | Selected Financial Data                                                                     |       | 29       |
| ITEM  7.   |       | Management’s Discussion  and Analysis of Financial Condition and Results of Operations |       | 30       |
|       |       | Overview                                                                                    |       | 30       |
|       |       | Critical Accounting  Policies                                                               |       | 30       |
|       |       | Results of Operations                                                                       |       | 31       |
|       |       | Liquidity and Capital  Resources                                                            |       | 33       |
| ITEM  7A.  |       | Quantitative and  Qualitative Disclosures About Market Risk                                 |       | 36       |
| ITEM  8.   |       | Financial Statements and  Supplementary Data                                                |       | 37       |
| ITEM  9    |       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure       |       | 62       |
| ITEM 9A.   |       | Controls and Procedures                                                                     |       | 62       |
| ** ** |       | **PART III**                                                                           |       |     |
| ITEM  10.  |       | Directors and Executive  Officers of the Registrant                                         |       | 63       |
| ITEM 11.   |       | Executive Compensation                                                                      |       | 63       |
| ITEM  12.  |       | Security Ownership of  Certain Beneficial Owners and Management                             |       | 63       |
| ITEM  13.  |       | Certain Relationships  and Related Transactions                                             |       | 63       |
| ITEM  14.  |       | Principal Accounting  Fees and Services                                                     |       | 63       |
| ** ** |       | **PART IV**                                                                            |       |     |
| ITEM  15.  |       | Exhibits, Financial  Statement Schedules and Reports on Form 8-K                       |       | 64       |
| SIGNATURES |       | 67                                                                                          |

 

In this report, “Tanox”,the “Company”, “we”, “us” and “our” refer to Tanox, Inc. and itssubsidiaries, unless the context otherwise suggests. “Common Stock” refers toTanox’s common stock, par value $0.01 per share.

Xolair®  (omalizumab) anti-IgE antibody is a trademarkof Novartis A.G.

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**PART I**

**ITEM 1. Business**

**Overview**

Tanox discovers and develops therapeutic monoclonalantibodies to address significant unmet medical needs in the areas ofimmune-mediated diseases, infectious diseases, inflammation and oncology. Tanox’sproducts are genetically engineered antibodies that target a specific moleculeor antigen. In addition, through collaborative agreements, Tanox receivesroyalties from the sale of Xolair® (omalizumab), our first product.

Our first product, Xolair, was developed in collaborationwith Genentech, Inc. and Novartis Pharma, A.G. Xolair received U.S. Foodand Drug Administration (FDA) marketing approval on June 20, 2003, and waslaunched in the U.S. in July 2003. Xolair is currently labeled fortreatment of adults and adolescents (12 years of age and above) withmoderate-to-severe persistent asthma who have a positive skin test or *in vitro* reactivity to a perennial aeroallergen and whosesymptoms are inadequately controlled with inhaled corticosteroids. Xolair is ananti-immunoglobulin E, or anti-IgE, antibody that has been shown to decreasethe incidence of asthma exacerbations in these patients. Safety and efficacyhave not been established in other allergic conditions.

On July 1, 2004, Novartis submitted anapplication for the European approval of Xolair as a treatment for allergicasthma. The proposed indication will focus on the prevention of asthmaexacerbations and control of symptoms in adults and adolescent patients withsevere persistent allergic asthma, who remain inadequately controlled despitethe use of inhaled corticosteroids, long-acting beta-2 agonists, as well asother controller medications.

In May 2004, Novartis, in cooperation withGenentech, initiated a Phase 3 clinical trial for Xolair in pediatric allergicasthma patients. The pediatric trial is designed as a randomized, double-blind,placebo-controlled, global study of one-year duration, which will enrollapproximately 570 patients between 6 and 12 years old. The primary objective ofthe study is to evaluate the efficacy and safety of Xolair in children withmoderate-to-severe, persistent and inadequately controlled allergic asthma.

In July 2004, the first patient was enrolled in aPhase 2 clinical trial evaluating the safety and efficacy of Xolair in patientssuffering from allergy (immediate hypersensitivity) to peanuts. The peanutallergy trial, which is being conducted by Genentech, is designed as a 38-week,multi-site study. Approximately 150 patients, between 6 and 75 years old withestablished peanut allergy, will be randomized 2-to-1 to receive Xolair orplacebo. The primary objective of the study is to assess the efficacy of Xolairin preventing peanut-induced allergic reactions in patients with peanutallergy.

We are also assessinganother product, TNX-355, as a treatment for the human immunodeficiency virus(HIV) and initiated a Phase 2 clinical trial of TNX-355 in May 2004. ThePhase 2 study is a three-arm, double-blind, placebo-controlled study, which wasfully enrolled as of the date of this report. All patients are anti-retroviraltherapy-experienced and will be on optimized background therapy (OBT) duringthe study. TNX-355 is a humanized, non-immunosuppressive anti-CD4 monoclonalantibody that works by blocking the ability of HIV to enter CD4 cells. The CD4receptor on host cell surfaces is considered to be a gateway for HIV infection.This monoclonal antibody is one of a relatively new class of drugs called viralentry inhibitors. Results from the Phase 1a study showed that TNX-355demonstrated clinically significant viral load reductions in patients infectedwith HIV, lasting approximately 2 to 4 weeks with a single dose. The Phase 1bmulti-dose administration study also demonstrated clinically significant viralload reductions that were maintained for 5 to 7 weeks. TNX-355 was safe andwell tolerated in the single dose and multi-dose studies. TNX-355 received FastTrack Status from the FDA in 2003. The objective of the current Phase 2 studyis to evaluate the safety and pharmacological activity of TNX-355 incombination with OBT as assessed by viral load reduction. TNX-355 will beadministered every two weeks 

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duringthe 48-week trial duration. There is a planned interim evaluation at 24 weeks,and we expect to report those data in the fourth quarter of 2005.

**Our Strategy**

Our objective is to become a profitable, fully integratedbiopharmaceutical company by developing, manufacturing and marketing innovativemonoclonal antibody products for the treatment of immune-mediated diseases, infectiousdiseases, inflammation and cancer. Keyaspects of our corporate strategy include the following:

·       *Expand the market opportunity for Xolair.*   In collaboration with Genentech and Novartis, weare continuing our efforts to expand the use of Xolair beyond adolescent and adultallergic asthma. This includes both geographic and label expansion. In 2004,Xolair was approved in Brazil, Canada and New Zealand, and submitted forapproval in the European Union. Clinical trials are under way to evaluateXolair’s effectiveness in treating pediatric allergic asthma and peanutallergy.

·       *Advance Our Product Pipeline.*   Our most-advanced clinical product, TNX-355, was shown to be welltolerated in Phase 1 clinical testing, with a reduction in viral load and nodepletion of CD4 cell count. We anticipate interim 24-week data from our Phase2 clinical trial in the fourth quarter of 2005 and have begun the process ofplanning for a Phase 3 study and developing a commercialization strategy. Wealso are focused on moving additional drug candidates through our pipeline andachieved progress in this regard in 2004 with both TNX-650 and TNX-717. Weanticipate filing Investigational New Drug (IND) applications for thesecandidates in 2005 and 2007, respectively.

·       *Expand Our Product PipelineThrough Acquisition and Licensing.*   In addition to our internal development efforts, we plan to selectivelylicense and acquire product opportunities and businesses that complement ourproduct pipeline and technology platform. We believe that we are wellpositioned to attract in-licensing and acquisition candidates as a result ofour expertise in monoclonal antibody technology and our strong financialposition.

·       *Form Strategic Collaborations to Support Development andCommercialization of Our Products.*   To enable us to develop products and to mitigate risk, we may deem itadvantageous to partner with other pharmaceutical and biotechnology companies. Thesepartnerships could allow us to obtain funding for our development,manufacturing and marketing activities, thereby reducing the substantialfinancial investment that is required to develop our products. They couldprovide us with domestic and international marketing and sales expertise forour partnered products. To the extent economically feasible, we expect toretain strategically important development, manufacturing or marketing rightsin order to maximize the value of our drug development opportunities.

·       *Strengthen our Operational Capabilities.*   To support research and development efforts andour clinical manufacturing and commercial supply needs, we will make strategicinvestments in technologies and other operational, enabling infrastructure toallow us to achieve full integration. To that end, in December 2004, weexecuted an agreement with Biogen IDEC to assume a long-term lease of a biologicsmanufacturing facility in San Diego, California, and to acquire certainmanufacturing assets in the facility. This transaction, which closed in January 2005,is expected to significantly expand our antibody production capacity.

**Monoclonal Antibodies**

Monoclonal antibodies representan exciting area of therapeutic product development. Genetically engineeredmonoclonal antibodies are man-made antibodies that target a specific antigen. Mostmonoclonal antibodies are derived from animals such as mice. When administeredto humans, monoclonal antibodies from animals are seen by the immune system asforeign, which can lead to adverse responses. 

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Antibodydesign technologies have enabled scientists to develop humanized (human-like)and fully human antibody products to address this potential problem. Advancesin antibody production technologies, such as high productivity cell culture andexperimental technologies such as transgenic plants and animals, have enabledmanufacturers to produce antibody products more cost-effectively. Manymonoclonal antibodies have been approved for marketing as therapeutics by theFDA, and a large number of monoclonal antibodies are currently underinvestigation in clinical trials.

Ourmonoclonal antibody therapeutics treat disease by altering the function of aspecific disease-causing protein, called a drug target. We have designed drugsto deactivate or reduce the activity of targets in the immune system for thetreatment of allergic and autoimmune disease, to block a target that preventssurvival of bone-building cells for the treatment of osteoporosis, and todisable a target that is used by HIV to infect human cells. Our products andproduct candidates have either resulted from internal research, werein-licensed or were acquired.

**Marketed Product—Xolair**

Xolair,the first anti-IgE antibody to reach the market, is also Tanox’s firstcommercial product. Xolair was approved by the FDA on June 20, 2003. Xolairgenerated approximately $188.5 million of sales in the U.S. in 2004, of whichTanox earned net royalties of $13.3 million. The current approved label forXolair is for treatment of adults and adolescents (12 years of age and above)with moderate-to-severe persistent asthma who have a positive skin test or *in vitro*reactivity to a perennial aeroallergen and whosesymptoms are inadequately controlled with inhaled corticosteroids. Xolair hasbeen shown to decrease the incidence of asthma exacerbations in these patients.Safety and efficacy have not been established in other allergic conditions.

***Mechanism of Action of Xolair***

Xolairis a recombinant humanized monoclonal antibody targeting IgE, one of the keyinflammatory proteins implicated in allergic diseases such as asthma, allergicrhinitis and food allergy. The immune system of an allergic individual respondsto an environmental protein, or allergen, by producing IgE that reacts with theallergen. IgE initially binds to the surface of mast cells and basophilsthrough high affinity IgE receptors on the cell surface. These cells are foundin tissue and also circulate in the blood, and they contain chemicals includinghistamine and leukotrienes, which provoke inflammation. When a mast cell orbasophil armed with allergen specific IgE on its surface comes into contactwith its cognate allergen, the allergen will cross-link the surface-bound IgEmolecules, with resultant cross-linking of the underlying IgE receptors. Thisevent signals the mast cell or basophil to release its powerful chemicals,causing tissue inflammation and asthma and allergy symptoms, includingbronchoconstriction, wheezing, coughing, sneezing, runny nose, watery eyes anditching. Xolair works by attaching to circulating IgE and masking the bindingsite for the IgE receptor which prevents IgE from binding to and arming mastcells and basophils. In this manner, Xolair reduces the inflammatory responseto allergens. Xolair also reduces the high-affinity IgE receptors on thesurface of white blood cells, further diminishing the allergic response.

***Market Opportunity—Moderate toSevere Allergic Asthma***

Asthmamakes breathing difficult and is potentially life threatening. Approximately35.6 million people in the top seven global markets (France, Germany, Italy,Spain, the United Kingdom, Japan and the United States) suffer from asthma. Approximatelytwo-thirds of these patients have allergic asthma. In the United States, thereare 17 million asthmatics, of which approximately 10 million receive treatment.Of the 10 million Americans treated for asthma, approximately 8.5 million patientsare age 12 and above, and 5.1 million of these 8.5 million patients have theallergic form of the disease. Of these, 4.2 million have IgE levels and bodyweight that fit within the dosing algorithm for Xolair, 1.9 million of thesepatients have 

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moderate-to-severe asthma, and 500,000 of them areuncontrolled by current medications. Xolair is being initially targeted to thispatient population of 500,000.

***Commercialization Status***

Genentech and Novartis, whichhave commercialization rights under our collaboration, launched Xolair in theU.S. in July 2003, with a 250 person sales force (125 salesrepresentatives from each company). This sales force is targeting sales andmarketing efforts at allergists and pulmonologists who specialize in thetreatment of asthma. Xolair is being distributed by a network of five specialtypharmacies:  Caremark Rx, CuraScriptPharmacy, Nova Factor, Option Care and Priority Healthcare.

Xolair generated approximately $188.5 million in U.S.sales in 2004, its first full year on the market, of which Tanox earned $13.3million in net royalties (after payments to our former attorneys and aftermilestone and other credits). Broad insurance coverage for Xolair has beensecured. The impact of the Medicare Modernization Act on Xolair is expected tobe minimal given that Xolair has a small Medicare patient population.

Xolair has also beenapproved for marketing in Australia, Brazil, Canada, Guatemala, New Zealand andVenezuela. The European Agency for the Evaluation of Medicinal Products (EMEA)is currently reviewing the Xolair marketing application for Europe, and weexpect that the EMEA will make a decision in mid-2005.

**Drugs in Development**

***Xolair***

Two clinical trials wereinitiated for Xolair in 2004 by our collaborators, Genentech and Novartis. InMay 2004, Novartis began a Phase 3 clinical trial of Xolair in pediatricallergic asthma patients. The pediatric trial is designed as a 12-monthrandomized, double-blind, placebo-controlled, global study, which will enrollapproximately 570 patients who are between 6 and 12 years old. The primaryobjective of the study is to evaluate the efficacy and safety of Xolair inchildren with moderate-to-severe, persistent and inadequately controlledallergic asthma. Asthma is the most common serious chronic disease ofchildhood, affecting nearly 5 million children in the U.S. Characterized bycoughing, chest tightness, shortness of breath and wheezing, asthma is thecause of almost 3 million physician visits and 200,000 hospitalizations eachyear.

In July 2004,Genentech began a 38-week, multi-site, Phase 2 clinical trial of Xolairin patients suffering from allergy (immediate hypersensitivity) to peanuts. Approximately150 patients, between 6 and 75 years old with established peanut allergy, willbe randomized 2-to-1 to receive Xolair or placebo. The primary objective of thestudy is to assess the efficacy of Xolair in preventing peanut-induced allergicreactions in patients with peanut allergy. Peanutallergy affects approximately 1.5 million people in the U.S., 50 to 100 of whomdie each year from unintended ingestion of foods containing peanuts or peanutderived ingredients. Current treatment is avoidance of peanuts and peanut oil,which is used in preparation of many food products. Complete avoidance requiresconstant vigilance and is difficult because prepared food labeling does notalways identify peanut-derived ingredients. Accidental exposures can result inserious allergic reactions and sometimes death. Patients with severe peanutallergy take antihistamines to prevent reactions to accidental exposure and mayrequire administration of epinephrine for severe anaphylactic reactions.

***TNX-355***

TNX-355 is a humanized, non-immunosuppressive anti-CD4monoclonal antibody that we are developing for treatment of humanimmunodeficiency virus (HIV). TNX-355 is a first-in-class CD4 

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receptor antagonist andpart of a new overall class of drugs known as viral entry inhibitors. HIVenters the host cell by binding to the CD4 receptors on the cells. In laboratory studies, TNX-355 binds to theCD4 receptor on the cell surface and prevents viral entry into the cell,thereby blocking cellular infection. Because it binds to a region of the CD4molecule that is not involved with normal immune function, laboratory studiesshow that TNX-355 does not suppress immune function in monkeys nor in humanblood cells. Results from Phase 1 studies, completed in 2003 and 2004, showedthat TNX-355 was well tolerated and can cause a transient but clinicallymeaningful reduction in viral load in patients infected with HIV, lastingapproximately 2 to 4 weeks with single-dose administration and 5 to 7 weeks inthe multi-dose administration trial. TNX-355 received Fast Track status fromthe FDA in October 2003.

*Market Opportunity*.   According to the World HealthOrganization, HIV infects approximately 1.5 million people in North America andWestern Europe. A number of drugs targeting viral replication are being used totreat the disease, often in combination with others. About 30% of the patientstreated with drug combinations no longer respond to the treatment since theirHIV has become drug resistant. In addition, many drug combinations produce avariety of undesirable side effects.

*Development Status and ClinicalResults.  *In May 2004, the Company initiated aPhase 2 study with TNX-355. The Phase 2 study is a three-arm, double-blind,placebo-controlled study, which was fully enrolled as of the date of thisreport. All patients in the study are anti-retroviral therapy-experienced and areon optimized background therapy (OBT). The objective of the 48-week study is toevaluate the safety and pharmacological activity of TNX-355 in combination withOBT as assessed by viral load reduction. The primary endpoint for the Phase 2trial is a significant reduction in viral load levels between either of theactive arms versus the control arm (OBT alone) after 24 weeks. A significantviral load reduction is defined as *>* 0.5 log10.Secondary objectives of the study are:  achange in percentage and number of CD4 cell count from baseline; the proportion(or number) of subjects who achieve a reduction of 1.0 log10 HIV-1RNA; the time to virologic failure; the extent of emergence of resistance; timeto loss of virologic response; and Average Area Under the Curve Minus Baseline.We expect to report interim 24-week data from the clinical trial in the fourthquarter of 2005. We have exclusive worldwide rights to TNX-355 through alicense from Biogen IDEC, Inc.

Inan open-label, single-dose, dose-escalating Phase 1a safety study in 30HIV-infected patients (J Infect Dis, 2004;189:286-291), TNX-355demonstrated dose-responsive decreases in viral load, with greater than one log10decreases in viral load observed at the 10 and 25 mg/kg dose. The drug was welltolerated in all dose groups (0.3 - 25 mg/kg). We have also completed amultiple-dose Phase 1b trial in 22 HIV-infected patients to further evaluatethe drug’s safety and effectiveness in reducing HIV-1 viral load. The resultswere presented at the 11th Conference on Retroviruses andOpportunistic Infections in San Francisco on February 11, 2004. In thisopen-label trial, patients were on a failing HAART (highly activeanti-retroviral therapy) regimen or on no other antiretroviral therapy andreceived one of three different regimens of TNX-355 (10 mg/kg weekly, 6 mg/kgbiweekly after a 10 mg/kg loading dose, and 25 mg/kg biweekly) for 8 to 9 weeks.Transient, clinically important (3 0.5 - 1.7 log10) reductions in viralload were observed in all but one patient, and 64% of patients experienced atleast a 1.0 log10 (90%) decrease in viral load. This studycontinued to demonstrate the tolerability and anti-retroviral activity ofTNX-355 observed in the Phase 1a study. As has been seen with otheranti-retroviral agents when tested as monotherapies (either as a single therapyor in combination with failing drug regimens), the viral load recovered despitecontinued administration of TNX-355, and an assessment of therapeutic potentialrequires evaluation of the drug in combination with other antiretroviralagents.

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**Our ResearchPrograms**

We are committed to identifying new drugs for treatinginflammatory and infectious diseases and cancer. A cornerstone of our discoveryeffort is our monoclonal antibody development platform which is asemi-automated, high-throughput system that gives us the capability to identifyand optimize individual monoclonal antibody leads in a 12-18 month timeframe. Monoclonalantibody candidates derived from mice are generally humanized to reduce thepossibility of immunogenicity, which could lead to decreased activity andtolerability in patients. Additionally, fully human monoclonal antibodycandidates are generated from phage libraries using technology licensed fromDyax Corp. (Dyax), a biotechnology company. Our antibodies are also optimizedfor affinity, effector function and circulating half-life to enhance theirtherapeutic potential.

Ourmonoclonal antibody therapeutics treat disease by altering the function of aspecific disease-causing protein, called a drug target. There can be one or moretargets for each disease, and some targets may be shared by more than oneindication. We select drug targets that are well-established in the scientificcommunity, as well as novel drug targets that are proprietary to Tanox. Identificationof novel targets typically involves a range of technologies includinggenome-wide expression profiling, proteomics, bioinformatics and transgenicmouse technologies. Once a new target has been identified and its relevance todisease has been confirmed or validated, proprietary monoclonal antibody drugcandidates are generated and selected based on their ability to preciselymodulate target function. We have the following product candidates inpreclinical development and research:
| **Investigational  Product** | ** ** | ** **                 | ** ** | **Target**                    | ** ** | **Proposed Indication** | ** ** | **Status** |
|------------------------------|------------|----------------------------|------------|-------------------------------|------------|-------------------------|------------|------------|
| TNX-650                      |       | Pro-Inflammatory  Cytokine |       | Inflammatory Diseases         |       | Preclinical             |
| TNX-717                      |       | Pro-Apoptotic Factor       |       | Osteoporosis                  |       | Research                |
| TNX-558                      |       | Complement C5a             |       | Inflammatory Diseases         |       | Research                |
| TNX-668                      |       | Pro-Inflammatory  Cytokine |       | Systemic Lupus  Erythematosus |       | Research                |
| TNX-336                      |       | Co-Stimulatory Molecule    |       | Autoimmune Diseases           |       | Research                |

 

Therapeutic monoclonal antibody candidates for certaintargets have been developed for the following indications:  an allergic mediator for allergic diseases,including the complement component C5a for various inflammatory indications;antagonists of two distinct pro-inflammatory cytokines for inflammatory diseaseand systemic lupus Erythematosus; a co-stimulatory molecule for autoimmunediseases, such as multiple sclerosis; and a proprietary cell signaling target(SARP2) for the treatment of diseases that result from reduced bone mineraldensity, such as osteoporosis. Initial validation of the latter target wasaccomplished in connection with the establishment of a cross-license agreementbetween Tanox and Wyeth, a US-based pharmaceutical and health care productscompany.

**Collaboration and Licensing Agreements**

***Collaborationwith Novartis and Genentech***

Our lead product, Xolair, was the result of a three-party collaborationwith Novartis and Genentech. In 1990, we established a collaboration withNovartis to jointly develop anti-IgE antibodies to treat allergic diseases. In connectionwith the settlement of a lawsuit in 1996, Genentech joined the collaboration forthe purpose of developing certain anti-IgE antibodies. In February 2004,we finalized the detailed terms of this three-party collaboration, whichprovides for the following:

·       *Development.  *Novartisor Genentech are responsible for conducting clinical trials and obtaining theregulatory approval for Xolair and the other anti-IgE products developedthrough the collaboration in the U.S. and Europe, and they share all relateddevelopment costs. We have primary development responsibility for collaborationproducts in China, Hong Kong, Korea, 

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Singaporeand Taiwan (East Asia), and we and Novartis equally share these developmentcosts. Novartis is responsible for development and associated costs in the restof the world.

·       *Manufacturing.  *Novartisand Genentech are responsible for manufacturing Xolair and other selectedanti-IgE products worldwide. In consideration for relinquishing any rights tomanufacture up to 50% of the worldwide requirements of those products, we willreceive quarterly payments from Novartis or Genentech based on the quantity ofproduct manufactured.

·       *Marketing.  *Novartisand Genentech share U.S. marketing rights and have each dedicated an equalnumber of sales representatives to promote Xolair in the U.S. Novartis hasmarketing rights outside the U.S.

·       *Milestone Payments.  *We may receive up to an additional $25.0 million in Xolair-relatedmilestone payments of which $7.2 million would be payable to our formerattorneys under an adverse arbitration ruling and $2.5 million would becreditable against future royalty payments. If a second drug were to bedeveloped under the collaboration, we could be eligible for additionalmilestone payments of $10.5 million.

·       *Royalties and Profit Sharing.  *In the United States, we receive royalties on sales of Xolair and othercollaboration products and will receive a share of Novartis’ profits on thesesales. We also receive royalties on sales of Xolair and other collaborationproducts outside the U.S. We share equally with Novartis the net profits andnet losses from sales of Xolair and other collaboration products in East Asia. Novartisprofit-sharing and rest-of-world royalty payments will be net of certain othercredits, which, at December 31, 2004, approximated $2.0 million. In addition,as a result of an adverse arbitration award, 10% of all royalties received byTanox on sales of Xolair and certain other anti-IgE products will be payable toour former attorneys, up to a maximum of $300 million. We expect that the netamount Tanox will receive from Xolair sales, taking into account both theforegoing credit and the amount payable to our former attorneys will be in therange of 8% to 12% of the net sales depending on the sales level achieved andgeographic distribution of the sales. Milestone and other credits caused thenet amount that Tanox received from Xolair royalties to be below 8% of netsales in 2004.

Either Novartis or Genentech maywithdraw from the collaboration, and, in such case, rights to Xolair and anyother products developed by the collaboration revert to us and the remainingcollaborator (or, if Genentech is the withdrawing party, to F. Hoffman-La RocheLtd., if Roche exercises its option to do so), depending on which party sharesrights with the withdrawing collaborator in a particular territory.

Inaddition to the collaboration described above, we and Genentech are parties toa cross-license agreement under which each has an option to license the otherparty’s patents that are necessary for the manufacture, use or sale of certainanti-IgE antibodies. This option may be exercised at any time if either partychooses to independently develop a product that does not fall within thecollaboration, if our collaboration with Novartis and Genentech terminates, orif we and Genentech mutually agree.

We are also party to anAmended and Restated Development and Licensing Agreement with Novartis underwhich we have agreed to collaborate on anti-IgE antibodies that do not fallwithin the three-party collaboration and, in general, are either (i) inventedand synthesized by Tanox or (ii) invented and synthesized by Novartis andderived from a Tanox antibody or would infringe certain Tanox patent rights.

***Other LicenseAgreements***

*Biogen IDEC.  *In 1998, we entered into an agreement to licensefrom Biogen, Inc. (now Biogen IDEC, Inc.) its anti-CD4 monoclonalantibody and intellectual property on an exclusive worldwide basis with limitedsublicensing rights. Biogen IDEC owns issued U.S., European, Canadian, HongKong and 

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Australianpatents and has pending applications in Japan, which cover our TNX-355product. We agreed to make royalty payments to Biogen IDEC based on annual netsales levels. In addition to royalty payments, we may make up to an aggregateof $1.4 million (which could be increased to an aggregate of $10.4 million inthe event we merge or affiliate with a company of similar size to Biogen IDEC)in product license fees and development milestone payments under thisagreement, of which we have paid $200,000. The license terminates on acountry-by-country basis on the later of the expiration of 12 years followingthe first commercial product sale or the expiration or invalidity of applicablepatents. The licensed patents expire in Europe in 2011 and in the United Statesin 2016, subject to extensions.

*Wyeth***.  **In November 2003, we entered into crosslicense agreements with Wyeth Pharmaceuticals Division, a division of Wyeth,with respect to patent rights covering a new class of drugs for the treatmentof osteoporosis. Under the agreements, Wyeth received a license under Tanoxpatents to develop a small molecule-based drug, and Tanox received a licenseunder Wyeth’s patent applications to develop an antibody-based drug. Theresearch is based on a proprietary target gene on which Tanox holds a patent. Underthe cross-licensing agreements, Tanox may receive milestone and royaltypayments with respect to Wyeth-developed products and may pay Wyeth milestonesand royalties with respect to Tanox-developed products. In 2003, we received anupfront license payment of $1.0 million from Wyeth.

*Dyax.  *In November 2004,we entered into an agreement with Dyax Corp. (Dyax) to obtain a non-exclusivelicense to its proprietary antibody phage display libraries. We intend toutilize the Dyax libraries to identify fully human monoclonal antibodies thatbind with high specificity and affinity to a number of our targets. Under theterms of the agreement, Dyax received an up front license fee of $900,000. Dyaxis also entitled to annual technology license fees, clinical milestone payments,and royalties upon successful commercialization by Tanox of products based onantibodies identified from the Dyax libraries.

**Patents and Proprietary Rights**

Proprietary protection for ourproducts, processes and know-how is important to our business. Our policy is tofile patent applications to protect technology, inventions, and improvementsthat we consider important to the development of our business. We continuallystrive for technological innovations to develop and maintain our competitiveposition. We aggressively prosecute our patents and protect our proprietarytechnology to maintain our proprietary position. Our success depends in largepart on our ability to obtain, protect and enforce commercially valuablepatents.

We hold or have in-licensed a numberof U.S. and foreign patents covering certain proprietary technology andproducts, with over 65 U.S. patents granted to date, as well as numerouspatents granted in Europe, Canada, Japan, Australia, Singapore, Hong Kong,Korea and several other Asian countries. One of the key families of patents wehold relates to anti-IgE antibodies and their use in the treatment ofallergy-related disease. These patents cover Xolair and are licensed toGenentech and Novartis under our three-party collaboration and to Novartisunder the Amended and Restated Development and Licensing Agreement. The patentsexpire between 2009 and 2013, subject to potential patent term extension. Inaddition, we co-own other anti-IgE related patents with Novartis. We also haveadditional pending applications related to the treatment of IgE mediateddisease.

Our portfolio also includes a family of patents thatwas in-licensed from Biogen IDEC related to anti-CD4 antibodies. These patentscover TNX-355, and the U.S. patent expires in 2016, subject to potentialpatent term extension as it applies to TNX-355. Foreign patents,including those in Europe, Canada, and Australia, will expire in 2011, subjectto potential patent term extension. The application in Japan is still pending. Wealso have patents related to complementpathway inhibitors and apoptosis-regulating proteins, including Bak and SARP.

Our commercial success depends on our ability tooperate without infringing the patents and other proprietary rights of thirdparties. In the event that our technologies may infringe patents or violate 

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proprietary rights ofthird parties, we may be prevented from pursuing product development,manufacturing or commercialization in that field. Such a result may materiallyharm our business, financial condition and results of operations. If ourantibody products or their commercial use or production meet all of therequirements of any of the claims of third-party patents, or patents that mayissue from third-party patent applications, then we may need a license to oneor more of these patents. We expect to seek to obtain licenses to such patentswhen, in our judgment, such licenses are needed. However, we cannot assure youthat we will be able to obtain any such license on commercially favorableterms, if at all. If these licenses are not obtained, we might be preventedfrom using certain of our technologies for the generation of our recombinantantibody products.

The scope, enforceability and validity of third partypatents, the extent to which we must obtain licenses under such patents orunder other proprietary rights and the cost and availability of licenses areunknown, but these factors may limit our ability to market our products. Moreover,even if a license were available, the payments that would be required couldrender our efforts to market certain of our products uneconomic. If we elect tomanufacture or market these products without either a license or a favorableresult in litigation, damages could be assessed that could be materiallyadverse to us. Further, failure to obtain a license could result in aninjunction prohibiting us from manufacturing or selling the affected lines ofproducts.

In addition to patents, werely on trade secrets and proprietary know-how. We seek protection in partthrough confidentially agreements. Our policy is to require all employees,consultants, advisors, outside scientific collaborations, sponsoredresearchers, and other advisors to execute confidentially agreements uponcommencing a relationship with Tanox.

**Government Regulation**

The manufacture and marketing ofour products and our research and development activities are subject toregulations relating to product safety and efficacy by numerous governmentalauthorities in the United States and other countries. In the United States,drugs are subject to rigorous FDA regulation. The Federal Food, Drug andCosmetic Act and other federal and state statutes and regulations govern, amongother things, the testing, manufacture, safety, effectiveness, labeling,storage, record keeping, approval, advertising and promotion of our products. Thelengthy process of seeking drug approvals, and the subsequent compliance withapplicable statutes and regulations, require the expenditure of substantialresources. Failure to comply with applicable regulations can result in refusalby the FDA to approve product license applications. The FDA also has theauthority to revoke previously granted product approvals.

Before we may market apharmaceutical product in the United States, the FDA requires us to complete aseries of preclinical and human clinical tests. Other countries have similarregulations. Preclinical tests include laboratory evaluations of productchemistry and animal studies to assess the potential safety and efficacy of theproduct and its formulations. The results of these studies must be submitted tothe FDA as part of the investigational new drug application (IND). Humanclinical trials cannot begin until the FDA approves the IND application. Clinicaltesting involves a three-phase process. In Phase 1, a small number of patientsor healthy volunteers are tested with the drug to assess its safety profile(adverse effects), dosage tolerance, metabolism, distribution, excretion andclinical pharmacology. In Phase 2, clinical trials are conducted with groups ofpatients afflicted with a specified disease in order to provide enough data toevaluate the preliminary efficacy, optimal dosage regimen and expanded evidenceof safety. In Phase 3, the drug is tested in a large number of patients with atarget disease to provide enough data to statistically evaluate the efficacyand safety of the product. We cannot assure you that we will successfullycomplete clinical testing of our products within any specified time period, ifat all. The results of the preclinical and clinical testing of the product arethen submitted to the FDA in the form of a biological license application (BLA)or new drug application (NDA), for marketing approval. In 

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respondingto a BLA or NDA, the FDA may grant marketing approval, request additionaltesting or information (either before or after approval) or deny theapplication if it determines that the application does not provide sufficientevidence of safety and efficacy for approval. We cannot assure you that FDAapproval will be obtained on a timely basis, if at all, for any of ourproducts.

In addition, the FDA requiresthe registration of each drug and approval of each manufacturing establishment.Since any approval granted by the FDA is both site and process specific, anymaterial change in the manufacturing process, equipment or locationnecessitates additional FDA review and approval. For our monoclonal antibodyproducts, we are subject to the procedures for biological products. Domesticmanufacturing establishments are subject to FDA inspection and must comply withcurrent good manufacturing practices (cGMP) for pharmaceutical products. Tosupply products for use in the United States, foreign manufacturingestablishments must comply with cGMP and are subject to periodic FDA or otherregulatory authority inspection under reciprocal agreements with the FDA.

For marketing outside the United States, we also aresubject to foreign regulatory requirements governing human clinical trials andmarketing approval for pharmaceutical products. The requirements governing theconduct of clinical trials, product licensing, pricing and reimbursement varywidely from country to country. Whether or not we obtain FDA approval, we mustobtain approval of a product by the comparable regulatory authorities offoreign countries before manufacturing or marketing the product in thosecountries. The approval process varies from country to country and the timerequired for these approvals may differ substantially from that required for FDAapproval. We cannot assure you that clinical trials conducted in one countrywill be accepted by other countries or that approval in one country will resultin approval in any other country.

In recent years, there have beennumerous proposals to change the healthcare system in the United States. Someof these proposals have included measures that would limit or eliminatepayments for medical procedures and treatments or subject pharmaceuticalproduct pricing to government control. In addition, as a result of marketplacepressures, third-party payors are increasingly attempting to contain healthcarecosts by limiting both coverage and the level of reimbursement of new drugproducts. Consequently, significant uncertainty exists as to the reimbursementstatus of newly-approved healthcare products. If we or any of our collaboratorssucceed in bringing one or more of our products to market, we cannot assure youthat third-party payors will consider them cost effective or allowreimbursement to the consumer at price levels sufficient for us to realize anappropriate return on our investment in product development or to even realizea profit. Significant changes in the healthcare system in the United States orelsewhere, including changes resulting from adverse trends in third-partyreimbursement programs, could materially reduce our profitability. Such changescould also significantly harm our ability to raise the capital we would need tocontinue our operations. Furthermore, if these proposals affect our collaborators,the proposals may harm our ability to commercialize the products we developjointly with them.

Inaddition to FDA regulations, we are subject to regulation under theOccupational Safety and Health Act, the Environmental Protection Act, the ToxicSubstances Control Act, the Resource Conservation and Recovery Act and otherpresent and future federal, state or local regulations.

**Competition**

The pharmaceutical andbiotechnology industries are characterized by rapidly evolving technology andintense competition. Many companies, including major pharmaceutical andchemical companies, as well as specialized biotechnology companies, performactivities similar to Tanox’s. Many of these companies have substantiallygreater financial and other resources, larger intellectual property estates,larger research and development staffs, and greater capabilities and experiencein preclinical testing, human clinical trials, regulatory affairs,manufacturing and marketing. We chose to enter into the collaboration agreementswith Novartis and Genentech, in part, to secure the benefit of their experiencein these areas, as well as the 

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contributionof their greater financial resources. In addition, colleges, universities,governmental agencies and other public and private research organizationsconduct research and may market commercial products on their own or throughjoint ventures. These institutions are becoming more active in seeking patentprotection and licensing arrangements to collect royalties for using technologythat they have developed. We also compete with these institutions in recruitingand retaining highly qualified scientific personnel.

The diseases that we havetargeted, including asthma, allergy, inflammation, other diseases affecting thehuman immune system, infectious diseases and cancer are intensely competitiveareas targeted by both pharmaceutical companies and other biotechnologycompanies, including Novartis and Genentech. All of these companies may havecompetitive products on the market, may be testing their products in clinicaltrials or may be focusing on product approaches that could prove to be superiorto our approaches. For instance, we are aware that some of these companies,which may be our competitors, have filed applications for or have been issuedpatents and may obtain additional patent and proprietary rights relating toproducts or processes used in, necessary to, competitive with or otherwiserelated to, our products or processes. These patents include, among otheritems, patents relating to humanized monoclonal antibodies.

Our competition will bedetermined in part by the potential indications for which our antibodies aredeveloped and ultimately approved by regulatory authorities. For some of ourpotential products, an important factor in competition may be the timing ofmarket introduction of our products or competitive products. Accordingly, weexpect the relative speed with which we develop our products, complete thenecessary approval processes and are able to generate and market commercialquantities of the products to be important competitive factors. We expect thatcompetition among products approved for sale will be based, among otherfactors, on product efficacy and safety, timing and scope of regulatoryapproval, product availability, advantages over alternative treatment methods,price and cost-effectiveness, development, distribution and marketingcapabilities, third-party reimbursement and patent position.

We are aware that severalcompanies, including Novartis, have existing products that compete with Xolair,including corticosteriods, beta-agonists, antihistamines, leukotrieneinhibitors, PDE4 inhibitors and allergen immunotherapy. In addition, severalother companies have products in development that may compete with Xolair. Thesecompanies include, but are not limited to, Biogen IDEC (Anti-CD23),CellTech/Schering-Plough (Anti-IL5), GlaxoSmithKline (Anti-IL5), Protein DesignLabs (Anti-IL2) and Genaera/MedImmune (Anti-IL9).

Our TNX-355 program willface competition from existing HIV therapies and particularly new viral entryinhibitors that target CCR5, CXCR4 and gp120 receptors, such as Fuzeon(Roche/Trimeris), PRO-542 and PRO-140 (Progenics), SCH-C and SCH-D(Schering-Plough), UK-427857 (Pfizer/Millenium), TAK-220 (Takeda),AMD070 (AnorMed) and 873140/ONO4128 (GlaxoSmithKline).

Our competitive position also depends upon our ability to:

·       discover or acquire and successfully develop new therapeutic productsthat successfully treat human diseases;

·       develop proprietary products or processes for which we can obtain patentprotection and secure necessary licenses under third party patents;

·       secure sufficient capital resources to complete product development andregulatory processes;

·       build or secure manufacturing capacity and manufacture efficiently;

·       enter into collaboration and licensing agreements on acceptable terms;

·       attract and retain qualified personnel;

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·       build or obtain a sales organization; and

·       achieve profitable commercial production of our products.

**Manufacturing**

We have two manufacturingfacilities, one owned in Houston, Texas and another leased in San Diego,California. Our Houston facility includes a 1,500L bioreactor system andpurification suite and occupies approximately 14,000 square feet of space. Wehave produced multiple lots of products for use in our Phase 1 and Phase 2clinical trials in this facility. On January 10, 2005, we assumed thelease on a GMP manufacturing facility in San Diego, California. The San Diegofacility occupies approximately 76,000 square feet and includes two 2,750Lbioreactor systems, purification and formulation suites, a small 500L clinicalmanufacturing suite, quality control laboratories, process development spaceand offices. We intend to use the San Diego facility for Phase 3 clinicalmanufacturing and potentially initial commercial product launch needs. Both theHouston and San Diego facilities are only capable of producing bulk products. Weoutsource fill and finish operations to contract manufacturing organizations.

Ourcurrent manufacturing facilities should provide adequate capacity formanufacturing our clinical trial materials for the foreseeable future. However,these facilities are not adequate for commercial scale manufacturingrequirements. Should TNX-355 or any of our other products succeed inclinical development and gain marketing approval, we will need commercial scalemanufacturing capacity. We will evaluate alternatives for securing commercialmanufacturing capacity, including the possible construction of a commercialplant on our own or entering into a long-term contract manufacturing agreementswith third parties.

**Research and Development**

Company sponsored researchand development expenses were $27.2 million, $21.0 million and $22.7 million in 2004, 2003 and 2002,respectively. We expect that research and development expenses will increase aswe seek to identify new product opportunities and expand development of ourcurrent and future product pipeline.

**Marketing and Sales**

Under our collaborationagreements, Novartis and Genentech have responsibility for marketing Xolair. Novartisand Genentech share U.S. marketing rights, and each company currently has adedicated sales force of 125 sales representatives marketing to allergists andpulmonologists. Novartis has marketing rights in Europe, where costs andprofits are shared with Genentech. Novartis has rights to market collaborationproducts in the rest of the world, and in China, Hong Kong, Korea, Singaporeand Taiwan, where costs and profits are shared with us.

To effectively serve theworldwide markets, we intend to continue to collaborate with majorpharmaceutical companies or prominent pharmaceutical sales and distributionorganizations that can successfully market our products on a worldwide basis orwithin specific geographic territories. As we pursue strategic collaborations,we intend to reserve marketing rights for our products, to the extentcommercially reasonable. We will focus initially on markets for which ourproducts have a clear advantage over other therapies or which we may targetusing a relatively small sales force. We currently do not have an internalsales and marketing capability. If we elect to retain marketing rights, we willhave to build a sales and marketing infrastructure.

Forfinancial information about geographic areas, please read Note 12 to ourconsolidated financial statements included in this Form 10-K.

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**Employees**

At December 31,2004, we had 127 full-time employees, all of which are based in the UnitedStates. We do not currently maintain key employee life insurance on any of ourpersonnel.

**Corporate History**

We were incorporated inDelaware in 2000 as the successor to a corporation formed in 1986 under thelaws of the State of Texas.

**Available Information**

Our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-Kand amendments to those reports are available free of charge on or through ourinternet website at http://www.tanox.com. These filings are also available tothe public at the Securities and Exchange Commission’s (SEC) Public Reference Room at450 Fifth Street, NW, Washington, DC 20549. The public may obtain informationon the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.Electronic filings with the SEC are also available on the SEC internet websiteat http://www.sec.gov.

**Forward-Looking Statements**

Some of the information in this Annual Report on Form 10-Kcontains forward-looking statements. We typically identify forward-lookingstatements by using terms such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,”“believe,” “estimate,” “predict,” “potential” or similar words, although weexpress some forward-looking statements differently. You should be aware thatactual events could differ materially from those suggested in theforward-looking statements due to a number of factors, including:

·       difficulties in developing safe and effective drugs;

·       failure to achieve positive results in preclinical and toxicology studiesin animals and clinical trials in humans;

·       failure to economically and timely manufacture sufficient amounts of ourproducts for clinical trials and commercialization activities;

·       failure to receive, or delay in receiving, marketing approval for ourproducts;

·       failure to successfully commercialize our products, including gainingmarket acceptance and achieving profitability in our operations;

·       our ability to manage relationships with collaboration partners;

·       our ability to obtain, maintain and successfully enforce patent and otherproprietary rights protection of our products;

·       variability of royalty, license and other revenues;

·       our ability to use our manufacturing capacity and facilities costseffectively and in accordance with regulatory requirements;

·       our ability to enter into future collaboration agreements to support ourresearch and development activities;

·       drug withdrawal from the market due to adverse reactions caused by themarketed drug;

·       our ability to secure licenses from third parties holding patents thatmay restrict the manufacture or marketing of our products;

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·       competition and technological change;

·       existing andfuture regulations affecting our business, including the content, timing ofsubmissions and decisions made by the FDA and other regulatory agencies;

·       governmental changesaffecting medicare and the healthcare and pharmaceutical industries, includingpolicies that affect coverage and levels of reimbursement for sales of ourproducts; and

·       our ability to hire andretain experienced scientists and managers.

Factorsthat could cause our actual results to differ from those set forth in theforward-looking statements include those set forth below, as well as thosediscussed elsewhere in this Form 10-K.

**Factors That May Affect Our Future Results**

***Regulatory Risks***

*Developing therapeutic monoclonal antibodies is expensive and highlyuncertain. If our preclinical and/or clinical trial results are negative, wemay be forced to stop developing products important to our future.*

Successful development oftherapeutic monoclonal antibodies is highly uncertain. First, we must discoveror otherwise acquire drug candidates. Then we must demonstrate throughpreclinical studies and clinical trials that our products are safe andeffective for use in a particular target indication before we can obtainregulatory approvals to sell our products commercially to that patient group. Thesestudies and trials tend to be very costly and time consuming. Furthermore, theresults of preclinical studies and initial clinical trials of our products donot necessarily predict the results from later-stage clinical trials, whichmust demonstrate the desired safety and efficacy traits.

Products that appear promising in early phases of development may not besubmitted for marketing approval for a number of reasons, including:

·       Our clinical trials fail to achieve their primary endpoint(s) andthe product is either not as effective as required or causes serious adversereactions or side effects in patients participating in the trials; often thesereactions may not be detectable in small, early stage trials and can only beidentified when the product is administered to a larger patient base, as inPhase 3 trials or following market approval;

·       The commercial introduction of competitive drugs that have greaterefficacy or safety than our product or otherwise adversely impact therisk/benefit profile of our product;

·       Inability to develop manufacturing methods that are efficient,cost-effective and capable of meeting stringent regulatory standards; and

·       Proprietary rights of third parties, which cover our products and forwhich we are not able to secure licenses on reasonable terms.

*We may be unable to enroll sufficient patients in a timely manner inorder to complete our clinical trials.*

The speed with which we are ableto enroll patients in clinical trials is an important factor in determining howquickly we may complete clinical trials and the cost of running those trials. Manyfactors affect patient enrollment, including the size of the patientpopulation, the proximity of patients to clinical sites, the eligibilitycriteria for the study, perceived risks and benefits of the drug under study,whether the drug will continue to be made available to the patient followingcompletion of the trial, and other ongoing trials directed at the sameindication. We may target our clinical trial protocols at indications that havesmall patient populations, which may make it difficult for us to enroll enoughpatients to complete the trials.

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Delays in patient enrollment inthe trials will result in increased costs and program delays, which could slowdown our product development and approval process, and could materially harmour business and results of operations.

*If we do not receive and maintain regulatory approvals, we will not beable to market our products.*

Our collaboration partners have secured approval tomarket Xolair in the United States, Australia, Brazil, Canada, Guatemala, NewZealand and Venezuela and submitted an application with the EMEA in June 2004for approval to manufacture and market Xolair in Europe. We cannot assure you that the applicationwill be accepted, or that Xolair will be timely approved, if at all, for salein Europe. Failure to secure EMEA approval could have a negative future effecton our income from Xolair sales and on our results of operations.

As a company, Tanox has not prepared or submitted any marketing approvalapplications to the FDA or any other regulatory agency for any of its products.As described above, the process that pharmaceutical products mustundergo to receive this approval is extensive, and includes preclinical testingand clinical trials to demonstrate safety and efficacy and a review of themanufacturing process to ensure compliance with cGMP. This process can lastmany years, be very costly and still be unsuccessful. The FDA can delay, limitor not grant approval for many reasons, including:

·       their belief that a product candidate is not safe and effective;

·       their interpretation of data from preclinical testing and clinical trialsin different ways than we interpret it;

·       failure of our manufacturing processes or facilities or those of ourcollaboration partners to meet cGMP standards; and

·       change in its approval policies and guidelines or adoption of newregulations.

We may also experiencedevelopment delays due to slow patient enrollment in clinical trials, delays insecuring clinical drug supply and unexpected manufacturing issues or requestsfrom the FDA for additional clinical data.

The process of obtainingapprovals to manufacture and market our products in foreign countries issubject to delay and failure for the same reasons.

Our products other than Xolairrequire significant additional laboratory development or clinical trials beforethey can be submitted for marketing approval. We have limited capacity toconduct and manage clinical trials and we rely on third parties, potentiallyincluding collaborative partners and contract research organizations, to assistus in these efforts. Our reliance on third parties may result in delays incompleting, or failing to complete, clinical trials if our collaborators orcontractors fail to perform under our agreements with them.

Continued approval of a productcandidate could also depend on post-marketing studies. In addition, anymarketed product and its manufacturer continue to be subject to strictregulation after approval. Any unforeseen problems with an approved product orany violation of regulations could result in restrictions on the product,including its withdrawal from the market.

Delays in receiving or failingto receive regulatory approvals, or losing previously received approvals, woulddelay or prevent product commercialization, which would adversely affect ourbusiness, financial condition and results of operations.

*We are subject to the uncertainty related to reimbursement policies andhealthcare reform measures.*

In recent years, there have beennumerous proposals to change the healthcare system in the United States. Someof these proposals have included measures that would limit or eliminatepayments for 

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medicalprocedures and treatments or subject pharmaceutical product pricing to governmentcontrol. In addition, as a result of marketplace pressures, third-party payorsare increasingly attempting to contain healthcare costs by limiting bothcoverage and the level of reimbursement of new drug products. Consequently,significant uncertainty exists as to the reimbursement status of newly-approvedhealthcare products. If we or any of our collaborators succeed in bringing oneor more of our products to market, we cannot assure you that third-party payorswill consider them cost effective or allow reimbursement to the consumer atprice levels sufficient for us to realize an appropriate return on ourinvestment in product development or to even realize a profit.

Significant changes in thehealthcare system in the United States or elsewhere, including changesresulting from adverse trends in third-party reimbursement programs, couldmaterially reduce our potential profitability. Such changes could alsosignificantly harm our ability to raise the capital we would need to continueour operations. Furthermore, if these proposals affect our collaborators, theproposals may harm our ability to commercialize the products we develop jointlywith them.

*Legislativeactions, potential new accounting pronouncements and higher insurance costs arelikely to impact our future financial position or results of operations.*

Future changes infinancial accounting standards, including proposed changes in accounting forstock options, may cause adverse, unexpected fluctuations in the timing or therecognition of revenues or expenses and may effect our financial position orresults of operations. New pronouncements and varying interpretations ofpronouncements have occurred with frequency and may occur in the future and wemay make changes in our accounting policies in the future. Compliance withchanging regulation of corporate governance and public disclosure, includingthe Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Marketrules, are creating uncertainty for companies such as ours and insurance costsare increasing as a result of this uncertainty and other factors. We arecommitted to maintaining high standards of corporate governance and publicdisclosure. As a result, we intend to invest all reasonably necessary resourcesto comply with evolving standards, and this investment may result in increasedgeneral and administrative expenses and a diversion of management time andattention from revenue-generating activities to compliance activities.

***Risks Relating to our Industry, Business and Strategy***

*Our ability tobecome a profitable fully integrated biopharmaceutical company will depend onthe continued commercial success of Xolair and on the success of TNX-355,which is still in development or our success in securing, developing andcommercializing new clinical candidates. If we are unable to commercialize TNX-355or experience significant delays in doing so, and if we are unable to securenew development candidates, our business may be harmed.*

We anticipate that, in the near term, our ability tobecome profitable will depend on the success of our collaboration partners ingenerating significant levels of sales of Xolair. In the longer term, animportant part of our strategy is to become a fully integratedbiopharmaceutical company. Our ability to do so will depend on the successfuldevelopment, approval and commercialization of TNX-355, our most advancedproduct candidate, or of potential new clinical stage drug candidates that wemay develop or otherwise license or acquire.

All of our current product candidates other than TNX-355are in preclinical development or in research, and we do not expect to seekregulatory approval of these candidates for many years, if ever. A significantportion of the research that we are conducting involves new and unproventechnologies. Research programs to identify new disease targets and productcandidates require substantial technical, financial and human resources whetheror not we ultimately identify any candidates. Our research programs mayinitially show promise in identifying potential product candidates, yet fail toyield product candidates for clinical development.

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In addition, if we do not achieve the clinicalendpoints in our Phase 2 study of TNX-355, or if the results of the trialindicate that further development and assuming marketing approval,commercialization of TNX-355, would not be economically viable, we maydetermine to terminate development.

We may be unable tolicense or acquire suitable product candidates or products from third partiesfor a number of reasons. The licensing and acquisition of pharmaceuticalproducts is highly competitive. A number of more established companies,including large pharmaceutical companies, are also pursuing strategies tolicense or acquire products in the fields in which we are interested. Theseestablished companies may have a competitive advantage over us due to theirsize, cash and other resources, and greater clinical development andcommercialization capabilities and experience. Other factors that may preventus from licensing or otherwise acquiring suitable product candidates includethe following:

·       wemay be unable to license or acquire the relevant technology on terms that wouldallow us to make an appropriate return from the product;

·       companiesthat perceive us to be their competitors may be unwilling to assign or licensetheir product rights to us; or

·       wemay be unable to identify suitable products or product candidates within ourareas of expertise.

Even if we are successful in developing and securingmarketing approval of TNX-355 or other in-licensed or acquired productcandidates, we may be unable to successfully launch, market or otherwisecommercialize the product.

If we are unable to develop suitable potential productcandidates through internal research programs or by acquiring drugs or drugcandidates from third parties, or if we are unable to successfully launch,market or commercialize the product(s) once approved for marketing, ourgoal of becoming a fully integrated biopharmaceutical company will not materialize,and our profit potential will be harmed.

*Failure to secure future collaboration partners for our other products orfailure by those partners to develop, manufacture, market or distribute thoseproducts, may delay or significantly impair our ability to generate revenues orprofit.*

We intend to rely on futurecollaboration partners to develop, manufacture, commercialize, market ordistribute certain of our other products. Many of our competitors are similarlyseeking to develop or expand their collaboration and license arrangements withpharmaceutical companies. The success of these efforts by our competitors couldhave an adverse impact on our ability to form future collaboration arrangements.The process of establishing collaborative relationships is difficult and timeconsuming and involves significant uncertainty. We cannot assure you that wewill be able to negotiate acceptable collaboration agreements in the future. Tothe extent that we are unable to enter into future collaboration agreements, wewould encounter increased capital requirements to undertake research,development and marketing at our own expense, and, in some cases, may have todiscontinue development of one or more products. Assuming we are able tocontinue to develop certain products on our own, we may experience significantdelays in introducing our product candidates or find that the absence of thesecollaboration agreements adversely affects our ability to manufacture or sellour product candidates, particularly outside the United States.

Even if we enter into future collaborative agreements, we cannot assureyou that efforts under these agreements will succeed because:

·       contracts with our partners may fail to provide significant protection ormay become unenforceable if one of these partners fails to perform;

·       our partners may not commit enough capital or other resources tosuccessfully develop, market or distribute our products;

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·       our partners may not continue to develop and commercialize productsresulting from our collaborations; and

·       disputes with our partners may arise that could delay or terminate ourproduct candidates’ research, development or commercialization or result insignificant litigation or arbitration.

If any of these risks occur, our product developmentand productivity may suffer.

*We face intense competition and rapid technological change that couldresult in products superior to the products we are developing.*

The biotechnology and pharmaceutical industries aresubject to rapid and significant technological change. We have numerouscompetitors in the United States and abroad, including, among others, majorpharmaceutical and chemical companies, specialized biotechnology firms,universities and other research institutions. These competitors may developtechnologies and products that are more effective or less costly than orotherwise preferable to any of our current or future products, and that couldrender our technologies and products obsolete or noncompetitive. Many of thesecompetitors have substantially more resources and product development,production and marketing capabilities than we do. In addition, many of ourcompetitors have significantly greater experience than we do in undertakingpreclinical testing and clinical trials of pharmaceutical products andobtaining FDA and other regulatory approvals of products for use in health care.If we succeed in achieving commercial sales of our products, we also will becompeting in commercial manufacturing efficiency and marketing capability,areas in which we have limited or no experience. Our competitors may obtain FDAapproval for products sooner or be more successful in manufacturing andmarketing their products than are we or our collaborators.

Products currentlyexist in the market that will compete directly with the products that we seekto develop. Any product candidate that we develop and that obtains regulatoryapproval must then compete for market acceptance among physicians, patients,healthcare payors and the medical community, as well as for market share. Significantfactors in determining whether we will be able to compete successfully include:

·       relative efficacy and safety of our products;

·       timing and scope of regulatory approval;

·       product availability;

·       potential advantages over alternative treatment methods;

·       development, marketing, distribution and manufacturing capabilities andsupport of our collaborators;

·       reimbursement coverage from insurance companies and others;

·       price and cost-effectiveness of our products;

·       patent protection for our products; and

·       availability of licenses under third party technology and patent rights.

If our products are notcompetitive based on these or other factors, our business, financial conditionand results of operations will be materially harmed.

*Failure to attract and retain key personnel and principal members of ourscientific and management staff could materially harm our business.*

Our success depends greatly onour ability to attract and retain qualified scientific, manufacturing, clinicaland other technical personnel, as well as to retain the services of ourexisting technical 

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managementstaff. To pursue our research and development programs and product developmentplans, we will be required to hire additional qualified clinical, scientific,manufacturing and other technical personnel. There is intensecompetition for qualified staff, and we cannot assure you that we will be ableto attract and retain the necessary qualified staff to develop our business. Thefailure to attract and retain these key personnel and management staff, or theloss of any of our current management team and our inability to replace him orher on a timely basis, could materially harm our business and financialcondition.

*We may be subject to product liability claims, and our insurance coveragemay not be adequate to cover these claims.*

Our business exposes us topotential product liability risks, which are inherent in testing,manufacturing, marketing and selling pharmaceutical products. We may be heldliable if any product we develop, or any product that uses or incorporates anyof our technologies, causes injury or is found otherwise unsuitable duringproduct testing, manufacturing, marketing or sale. We cannot assure you that wewill be able to avoid product liability exposure.

Product liability insurance forthe biopharmaceutical industry is generally expensive. Although we currentlymaintain product liability insurance covering our products in amounts webelieve to be commercially reasonable, we cannot assure you that our coverageis adequate or that continued coverage will be available at acceptable costs. Inaddition, some of our license and collaboration agreements require us to obtainproduct liability insurance. Future license and collaboration agreements mayalso include such a requirement. Our inability to obtain sufficient insurancecoverage at an acceptable cost or otherwise to protect against potentialproduct liability claims could prevent or inhibit us or our collaborators fromcommercializing our products. A successful claim in excess of our insurancecoverage could materially harm our business, financial condition and results ofoperations.

*We deal with hazardous materials and must comply with environmental lawsand regulations, which can be expensive and restrict how we do business.*

Our research and development work and manufacturingprocesses involve the controlled use of hazardous materials, includingchemical, radioactive and biological materials. Our operations also producehazardous waste products. We are subject to federal, state and local laws andregulations governing how we use, manufacture, store, handle and dispose ofthese materials. Although we believe that we comply in all material respectswith applicable environmental laws and regulations, we cannot assure you thatwe will not incur significant costs to comply with environmental laws andregulations in the future. In addition, current or future environmental lawsand regulations may impair our research, development or production efforts.

*We could be liable for damages, penalties or other forms of censure if weare involved in a hazardous waste spill or other accident.*

Despiteprecautionary procedures that we implement for handling and disposing ofhazardous materials, we cannot eliminate the risk of accidental contaminationor discharge or any resultant injury from these materials. If a hazardous wastespill or other accident occurs, and we are held liable for damages, theliability could exceed our financial resources.

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***Risks Associated with Manufacturing and Marketing***

*Our revenues are dependent on sales of Xolair. Failure to receive marketacceptance for and successfully commercialize Xolair would have a significantadverse effect on us.*

Our results ofoperations and future prospects are highly dependent on increasing the sales ofour only commercial product, Xolair. Our revenues in 2004 consisted largely ofrevenue from product sales of Xolair, and we expect that revenues from sales ofXolair will constitute a larger percentage of our revenue in the next severalyears. Even though the FDA approved Xolair and initial insurance andMedicare/Medicaid coverage is encouraging, we cannot be certain that physiciansand patients will continue to widely accept Xolair as a treatment for itsapproved indication in the United States or in any foreign markets. A number offactors may affect the rate and level of Xolair’s market acceptance, including:

·       the effectiveness of Novartis’ and Genentech’s sales and marketingefforts;

·       the perception by physicians and other members of the healthcarecommunity of Xolair’s safety, efficacy and benefits compared to those ofcompeting products or therapies;

·       the willingness of additional physicians to adopt a new asthma treatmentregimen;

·       Xolair’s price relative to other products or competing treatments;

·       the availability of third-party reimbursement;

·       the ability to conduct the Phase 4 commitment studies and the impact ofthe study results on the labeling of Xolair;

·       regulatory developments related to manufacturing or using Xolair;

·       the results of product development efforts for new indications of Xolair,and the scope and timing of additional marketing approvals and favorablereimbursement programs for any such expanded use;

·       availability of sufficient commercial quantities of Xolair;

·       increased competition for Xolair from new or existing products, which maydemonstrate better safety, efficacy or cost-effectiveness than Xolair; and

·       adverse side effects or unfavorable publicity concerning Xolair.

If the level of Xolair salesdeclines or fails to increase, our financial condition, results of operationsand future potential would be significantly harmed.

*We have limited experience inmanufacturing and may encounter manufacturing problems or delays that couldresult in lost revenue or delayed clinical trials.*

Tanox owns a manufacturingfacility in Houston, Texas, and recently assumed the lease on a manufacturingfacility in San Diego, California, which we intend to use to manufactureclinical trial materials and potentially initial commercial products.

To develop products, we requiresufficient quantity and quality of manufactured product for clinical trials. Regulatoryor technical manufacturing issues could delay clinical development of products.Any failure to produce these clinical requirements, either as a result of ourinability to produce in accordance with cGMP or inadequate manufacturingcapacity, can delay the commencement or continuation of our clinical trials.

To commercialize our productssuccessfully, we and our collaboration partners must manufacture our productsin commercial quantities in compliance with regulatory requirements and at anacceptable cost. If 

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themanufacturing facilities used to produce our products cannot pass a pre-approvalor periodic plant inspection, the FDA may not approve our products or it maydelay or bar their sale. In order to obtain regulatory approvals and to createcapacity to produce our products in sufficient quantities for commercial saleat an acceptable cost, we will have to develop or acquire additional technologyfor commercial scale manufacturing and build or otherwise obtain access toadequate facilities, which will require substantial additional funds. We willalso be required to demonstrate to the FDA and corresponding foreignauthorities our ability to manufacture our products using controlled,reproducible processes. We cannot assure you that we, operating alone or withthe assistance of others, can develop the necessary manufacturing technology orthat we will be able to fund or build an adequate commercial manufacturingfacility necessary to obtain regulatory approvals and to produce adequatecommercial supplies of our potential products on a timely basis.

*We lack sales and marketingexperience, which makes us depend on third parties for their expertise in thisarea.*

Underour current collaboration agreement, Novartis and Genentech have exclusivemarketing rights to Xolair and other collaboration anti-IgE products, andrevenues we receive from Xolair will depend primarily on the efforts of ourcollaboration partners. However, commercialization rights may revert back to usif our collaborators terminate our relationship, and we currently have nosales, marketing or distribution capabilities. Furthermore, we intend to retainmarketing rights, particularly in the United States and selected Asiancountries, for other potential products that we can develop and selleffectively with a small, targeted sales force. If we elect to market productsdirectly, we would require significant management resources and have to makesignificant additional expenditures to develop an internal marketing functionand a sales force. We cannot assure you that we would be able to establish asuccessful sales force should we choose to do so.

***Risks Related to Financial Results and Need forFinancing***

*We have a history of net losses;we expect to continue to incur net losses and we may never achieve or maintainprofitability*.

We have incurred net lossessince our inception. As of December 31, 2004, we had an accumulateddeficit of approximately $93.8 million, including a net loss of approximately$10.3 million for the year ended December 31, 2004. Our losses haveprimarily been the result of costs incurred in our research and developmentprograms and from our general and administrative costs.

We have funded our operationsprincipally from licensing fees, royalty revenue and milestone payments underour current or former collaborations, as well as with proceeds from privateplacements and an initial public offering of our common stock. We expect tocontinue to incur substantial operating losses until such time, if ever, thatwe are able to generate sufficient revenue from milestone payments, royaltiesand profit-sharing payments on Xolair sales and, potentially, revenues from anadditional product or products to cover our expenses.

Our ability to achieve andmaintain long term profitability depends to a significant extent on thecontinued successful commercialization of Xolair, and also on our successfullycompleting preclinical and clinical trials, obtaining required regulatoryapprovals and successfully manufacturing and marketing our other current andfuture product candidates. We cannot assure you that we will be able to achieveany of the foregoing or that we will be profitable even if we successfullycommercialize our products.

*Failure by Novartis or Genentechto develop, manufacture, market or distribute Xolair would impair our abilityto generate revenues.*

Under the terms of ourcollaboration agreements, Novartis and Genentech are generally responsible forconducting clinical trials on, obtaining regulatory approval for, andmanufacturing, marketing and 

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distributingXolair. Our ability to profit from the products covered by our collaborationagreements with Genentech and Novartis depends in large part on theirperformance. We cannot control the amount and timing of resources Novartis andGenentech will devote to any of our products. If Novartis or Genentechexperiences manufacturing or distribution difficulties, does not activelymarket Xolair or other partnered anti-IgE products or does not otherwiseperform under our collaboration agreements, our potential for revenue fromthose products will be dramatically reduced. Novartis and Genentech mayterminate our collaboration agreements, and, in that event, we would experienceincreased capital requirements to undertake development and marketing at ourexpense. We cannot assure you that we would be able to manufacture, market anddistribute Xolair or our other anti-IgE products on our own.

*We may need additionalfinancing, but our access to capital funding is uncertain, and issuance ofadditional common stock could dilute existing stockholders.*

Our current and anticipated development projects require substantialadditional capital. While we expect that our cash on hand, together with ourrevenue from Xolair, will fund our existing operations for the next four years,our future capital needs will depend on many factors, including the commercialsuccess of Xolair, receiving royalty and milestone payments from ourcollaboration partners, making progress in our TNX-355 clinical trial, researchand development activities and entering into additional collaborationagreements. Our capital requirements may also depend on the progress and levelof costs associated with preclinical studies and clinical trials, the costsassociated with acquisitions of new product candidates by licensing orotherwise, the costs of preparing, filing, prosecuting, maintaining andenforcing patent claims and other intellectual property rights, competingtechnological and market developments, changes in or terminations of existingcollaboration and licensing arrangements and the cost of manufacturing scale-upand development of marketing activities, if undertaken by us. We do not havecommitted external sources of funding and we cannot assure you that we will beable to obtain additional funds on acceptable terms, if at all. If adequatefunds are not available, we may be required to:

·       delay, reduce the scope of or eliminate one or more of our developmentprograms;

·       obtain funds through arrangements with collaboration partners or othersthat may require us to relinquish rights to technologies, product candidates orproducts that we would otherwise seek to develop or commercialize ourselves; or

·       license rights to technologies, product candidates or products on termsthat are less favorable to us than might otherwise be available.

We may raise additional funds byissuing additional stock, which would cause further dilution to ourstockholders, and new investors could have rights superior to existingstockholders. If funding is insufficient at any time in the future, we may beunable to develop or commercialize our products, take advantage of businessopportunities or respond to competitive pressures, and our business andfinancial condition may be harmed.

*The market price of our common stock has beenvolatile.*

Like other stocksof biopharmaceutical companies, the market price for our common stock has beenand may continue to be volatile. During the last two years, our stock priceranged from $8.03 to $22.74. Factors that contributed to the volatility of ourstock during this period included:

·       FDAapproval of Xolair;

·       Reportedsales volume of Xolair;

·       Resultsof clinical trials; and

·       Generalmarket conditions, including particularly the biotechnology company segment.

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***Risks Relating to Intellectual Property***

*The patentability, validity, enforceability andcommercial value of our patents are highly uncertain. If our intellectualproperty positions are challenged, invalidated or circumvented and we fail toprevail in resulting intellectual property litigation, our business could beadversely affected.*

Our success depends in part on obtaining, maintainingand enforcing patents and maintaining trade secrets. While we file andprosecute patent applications to protect our inventions, our pending patentapplications may not result in the issuance of valid patents and our issuedpatents may not provide competitive advantages. Also, our patents may notprevent others from developing competitive products using related or the sametechnology. We cannot assure you that pending patent applications developed byor licensed to us will result in patents being issued or that, if issued, thepatents will give us an advantage over competitors with similar technology.

We own or have licenses to certain issued patents. Thepatents we own that are most material to our business are five U.S. patents andsix foreign patents relating to anti-IgE antibodies. However, the patentposition of biotechnology and pharmaceutical firms is highly uncertain andinvolves many complex legal and technical issues. There is no clear policyinvolving the breadth of claims allowed or the degree of protection affordedunder such patents. Issued patents can be challenged in litigation in thecourts and in proceedings in the United States Patent and Trademark Office andin courts and patent offices in foreign countries. Issuance of a patent is notconclusive as to its validity, enforceability or the scope of its claim. Wecannot assure you that our patents will not be successfully challenged as toenforceability, invalidated or limited in the scope of their coverage. Moreover,litigation to uphold the validity of patents and to prevent infringement can bevery costly and can result in diverting technical and management personnel’stime and attention, which may materially harm our business, financial conditionand results of operations. If the outcome of litigation is adverse to us, thirdparties may be able to use our patented technology without paying us. Moreover,we cannot assure you that our patents will not be infringed or successfullyavoided through design innovation. Any of these events may materially andadversely affect our business.

In addition to the intellectual property rightsdescribed above, we also rely on unpatented technology, trade secrets andconfidential information. We cannot assure you that others will notindependently develop substantially equivalent information and techniques orotherwise gain access to our technology or disclose such technology, or that wecan effectively protect our rights in unpatented technology, trade secrets andconfidential information. We require each of our employees, consultants andadvisors to execute a confidentiality agreement at the commencement of anemployment or consulting relationship with us. We cannot assure you, however,that these agreements will provide effective protection if an unauthorized useor disclosure of this confidential information occurs.

*If we fail to obtain any required patent license fromthird parties, our product development efforts could be limited.*

Our commercial success depends on our ability to operatewithout infringing the patents and other proprietary rights of third parties. Other companies, some of which may be ourcompetitors, have filed applications for or have been issued patents, and mayobtain additional patents and proprietary rights, relating to products orprocesses used in, necessary to, or otherwise related to our products andproduct candidates.

For example, we are aware of broad patents owned byothers relating to the manufacture, use and sale of recombinant humanizedantibodies. Many of our product candidates are genetically engineeredrecombinant humanized antibodies. If our antibody products or their commercialuse or production meet all of the requirements of any of the claims of theaforementioned patents, or other third party patents or patent applications,then we may need a license to one or more of these patents. We expect to seekto obtain patent licenses when, in our judgment, such licenses are needed.  Even if we determine that a 

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license is not necessary,a patent holder could disagree and sue us for damages and seek to prevent usfrom manufacturing, selling or developing our products. Legal disputes can becostly and time consuming to defend. If any patent holder successfullychallenges our judgment that our products do not infringe their patents or thattheir patents are invalid, we could be required to pay costly damages or toobtain a license to sell or develop our drugs. If we determine that a licenseis required, there can be no assurance that we will be able to obtain thelicense on commercially reasonable terms, if at all. If we are unable to securea required license, we might be prevented from using certain of ourtechnologies for the generation and manufacture of our recombinant antibodyproducts or from pursuing product development, manufacturing orcommercialization in a particular field, and this may materially harm ourbusiness and financial prospects.

In addition to patents, werely on trade secrets and proprietary know-how. We seek protection in partthrough confidentiality agreements. We cannot assure you, however, that theseagreements will provide meaningful protection of our proprietary information ortrade secrets in the event of an unauthorized use or disclosure or that ourvaluable trade secrets will not become known to, or independently developed, byour competitors.

**Executive Officers of Tanox**

Our executiveofficers and other key employees and their ages and positions with Tanox are:

*Executive Officers:*
| **Name**                    | ** ** | ** ** | ** ** | **Age**                                        | ** ** | **Position** |
|-----------------------------|------------|------------|------------|------------------------------------------------|------------|--------------|
| Nancy  T. Chang, Ph.D.      |       | 55         |       | President  and Chief Executive Officer         |
| Edward  Hu, M.B.A.          |       | 42         |       | Vice  President of Operations                  |
| Matthew  Moyle, Ph.D.       |       | 44         |       | Vice  President of Research                    |
| Gregory  P. Guidroz, C.P.A. |       | 52         |       | Vice  President of Finance                     |
| Katie-Pat Bowman, J.D.      |       | 50         |       | Vice President, General  Counsel and Secretary |

 

*Other Key Employees:*
| **Name**                    | ** ** | ** ** | ** ** | **Age**                                                         | ** ** | **Position** |
|-----------------------------|------------|------------|------------|-----------------------------------------------------------------|------------|--------------|
| Ashraf  Hanna, Ph.D., M.D.  |       | 37         |       | Vice  President of Strategic Planning                           |
| Danong  Chen, Ph.D., M.B.A. |       | 44         |       | Vice President of Corporate  Development and Project Management |
| Hugo  Santos                |       | 54         |       | Vice  President of Human Resources                              |
| Todd Winge                  |       | 40         |       | Senior Director of  Manufacturing                               |

 

**Nancy T. Chang, Ph.D.,** is one of our co-founders and has served as ourPresident since our organization in March 1986. Dr. Chang has servedas our Chief Executive Officer since June 1990 and was Chairman of theBoard of Directors from organization through October 2003. From 1986 to1992, Dr. Chang served as an Associate Professor at Baylor College ofMedicine in the Division of Molecular Virology. Between 1981 and 1986, Dr. Changwas employed by Centocor, Inc., serving as the Director of Research,Molecular Biology Group, from 1984 to 1986. From 1980 to 1981, she was employedby Roche Institute of Molecular Biology. Dr. Chang received her Ph.D. inBiological Chemistry from Harvard University.

**Edward Hu, M.B.A.,** was promotedto Vice President of Operations in January 2005. From January 2004until January 2005, Mr. Hu had served as Vice President—FinancialPlanning, Project & Portfolio Management., where he managed bothinternal and collaborative projects and oversaw the project portfolio reviewprocess. Mr. Hu had been Director of Finance from July 2002 to January 2004and 

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previously served asAssociate Director of Financial Planning and Analysis from the time he joinedTanox in October 2000. From 1998 to 2000, he held the position of Managerof Financial Planning and Analysis with Biogen, Inc. (n/k/a Biogen IDEC, Inc.),where he managed the business planning of Biogen’s R&D and clinicaloperations, managed long range planning, and provided project planning andanalysis support to key development project teams. From 1996 to 1998 he was aSenior Financial Analyst with Merck & Co., Inc. Mr. Hureceived his MBA and completed his Ph.D. work, all but dissertation, inBiophysics and Biochemistry at Carnegie Mellon University.

**Matthew Moyle, Ph.D.,**joined usas Vice President of Research in January 2001. Prior to that, he heldvarious positions with Amgen, Inc., a biotechnology company, since October 1995,including most recently Department Head of Expression Profiling andPharmacogenomics. From July 1991 to September 1995 he held seniorresearch positions with Corvas, Inc. where he was involved in thediscovery and development of two biological agents. While at Amgen and Corvas, Dr. Moylewas actively involved in recruiting scientists and establishingmulti-disciplinary project teams. He also participated in licensingtransactions. Dr. Moyle received both his Ph.D. and B.Sc. degrees inBiochemistry from the University of Toronto.

**Gregory P. Guidroz, C.P.A.**, has served as our Vice President of Financesince July 2002. Prior to joining Tanox, Mr. Guidroz served as ChiefFinancial Officer for Integrated Diagnostic Centers, Inc., a diagnosticimaging center company, from July 1999 until July 2002. He wasCo-Founder and Chief Financial Officer for NPPA of America, Inc., amulti-state provider of nurse practitioner and physician assistant services,from April 1998 until March 1999 when it was acquired. From June 1995until March 1998, he was a Principal with Healthcare Solutions, Inc.,a healthcare management consulting firm. From November 1975 until May 1995,Mr. Guidroz held Chief Financial Officer or Controller positions invarious healthcare and software corporations. He began his career on the auditstaff of Arthur Andersen after receiving a BBA from Lamar University. Mr. Guidrozwas also a Partner with Tatum CFO Partners, LLP from July 1999 through April 2004.

**Katie-Pat Bowman, J.D.,**hasserved as our Vice President, General Counsel and Secretary since July 2000.Prior to that she was Senior Corporate Counsel and Assistant Secretary forLyondell Chemical Company from September 1999 until July 2000. Shewas Vice President and General Counsel for Daniel Industries Inc., a pipelineequipment manufacturer, from September 1997 until September 1999,when it was acquired by Emerson Electric Company. Prior to that, she practicedlaw with Houston-based law firms Haynes & Boone LLP and Fulbright &Jaworski, L.L.P. since 1987. Ms. Bowman, a CPA, practiced publicaccounting and worked in industry as an accountant from 1977 through 1987. Shereceived both a Juris Doctorate and BBA from the University of Houston.

**Ashraf Hanna, Ph.D., M.D.,** hasserved as Tanox’s Vice President of Strategic Planning since August 2002,a role in which he directs the development and assessment of the company’scorporate strategy. From August 2001 until July 2002, Dr. Hannaserved as the Director of Strategic Planning. Prior to joining Tanox, from June 2000to July 2001, Dr. Hanna completed his residency at Metrowest MedicalCenter and, from 1996 to 2000, attended medical school at the University ofMassachusetts. From 1992 to 1996, Dr. Hanna served as engagement managerat McKinsey & Company, a consulting firm. Before that, Hanna worked asa research associate at Harvard Business School. Dr. Hanna obtained hisPh.D. in physics from Harvard University and attended Harvard Business School. Healso obtained a doctor of medicine from the University of Massachusetts.

**Danong Chen, Ph.D., M.B.A.,** waspromoted to Vice President of Corporate Development and Project Management in January 2005.She is responsible for evaluating new product opportunities, potential mergerand acquisition transactions and overseeing corporate projects. From January 2004until January 2005, Dr. Chen served as Director of CorporateDevelopment and, from March 2002 until December 2003, as AssociateDirector of Corporate Development. Prior to joining Tanox, Dr. Chen servedas a manager in the healthcare practice of Arthur D. Little, Inc., astrategic consulting company, 

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from 1999 to March 2002,where she managed and participated in projects ranging from benchmarkingpharmaceutical research and development, evaluating contract manufacturingorganizations to multinational product launch strategy. Dr. Chen receivedher Ph.D. in Neuroscience from Baylor College of Medicine.

**Hugo Santos** has been our VicePresident of Human Resources since December 2004. Prior to joining Tanox, Mr. Santoswas co-founder and Vice President of the Human Capital Practice for HR Drivers,a consulting firm in San Francisco, California, from November 2001 until December 2004when the firm was sold. From October 2000 until November 2001, Mr. Santosserved as Executive Vice President of Human Resources for JNI Corporation inSan Diego, California, a designer and supplier of enterprise storageconnectivity products. From November 1994 through October 2000, Mr. Santoswas Vice President of Human Resources for Applied Biosystems Corporation inFoster City, California, a supplier of life science technology. For 10 yearsprior to that, Mr. Santos worked for National Semiconductor Corporationwhere he held a variety of Human Resources positions. He received his B. A. inlabor relations from Pace University in New York.

**ToddWinge** joined Tanox as Senior Director, Manufacturing, in June 2004.From December 1999 to May 2004, he held various positions withDiosynth Biotechnology (formerly Covance Biotechnology Services, Inc.), acontract biotechnology manufacturing organization, including most recentlyDirector of Fermentation, Cell Culture, Recovery and Refold Manufacturing. FromSeptember 1988 to December 1999, he held various positions in processdevelopment and cGMP clinical manufacturing at Scios, Inc. (formerly CalBio, Inc.), a Biotechnology company. Prior to that, he worked forUniversal Bioventure, a contract manufacturing organization and division ofUniversal Foods, Inc. Mr. Winge received his B.S. in BiomedicalEngineering from Marquette University.

**Scientific Advisors**

An important component of ourscientific strategy is to establish collaborative relationships with leadingresearchers in our fields of interest. Certain of our scientific advisorsattend periodic meetings and provide us with specific expertise in bothresearch and clinical development. In addition, we have collaborative researchrelationships with certain individual advisors. We do not employ our scientificadvisors, and they may have commitments to or consulting or advisory agreementswith other entities. In general, our scientific advisors may hold stockoptions, own our stock and/or receive financial remuneration for theirservices.

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Our scientific advisors are:
| **Name**                                  | ** ** | ** **                                                                                                                                                                                                                                    | ** ** | **Title and Affiliation** |
|-------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|
| John  Atkinson, M.D.                      |       | Professor  of Molecular Microbiology, Department of Internal Medicine, Division of  Rheumatology, Washington University School of Medicine                                                                                                    |
| K.  Frank Austen, M.D.*                   |       | Director, Inflammation and Allergic Diseases Research Section, Brigham  and Women’s Hospital, Division of Rheumatology, Immunology and Allergy,  AstraZeneca Professor of Respiratory and Inflammatory Diseases, Harvard  Medical School |
| Yong-Jun  Liu, M.D., Ph.D.                |       | Chairman of Department of Immunology, Director of Center for Cancer Immunology  Research, The University of Texas M.D. Anderson Cancer Center                                                                                                 |
| Donald  MacGlashan, Jr., M.D., Ph.D. |       | Professor of Medicine, Johns Hopkins Asthma and Allergy Center                                                                                                                                                                                |
| Robert T. Schooley, M.D.                  |       | Professor  of Medicine and Head, Division of Infectious Diseases, University of  California, San Diego                                                                                                                                        |

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*                    Chairman

**ITEM 2. Properties**

Our research and development, process development,administrative and pilot scale manufacturing activities are conducted out oftwo buildings, which we own, in Houston, Texas, having approximately 68,000 and43,000 square feet. These facilities are suitably equipped, and we believe thatthey are adequate for our current and near term purposes. We also ownapproximately 28 acres of land adjacent to these facilities in Houston.

Effective January 10,2005, we entered into a lease for a 76,000 square foot biologics manufacturingfacility located in San Diego, California. We expect that this facility, whichhouses two 2,750 liter bioreactor systems, will be capable of manufacturingclinical supplies for Phase 3 studies and potentially supplies for initialcommercial launch. We are currently in the process of re-commissioning thefacility, which had been previously leased by Biogen IDEC. Our lease extendsuntil October 2011, with two five-year extension options. While we believethat this facility will meet our immediate and near term needs, as our productscontinue to advance in development and to the extent that they arecommercialized and we have retained manufacturing rights, we will likelyrequire additional manufacturing capacity.

**ITEM 3. Legal Proceedings**

Asof the date of this report, Tanox has no material pending legal proceedings.

**ITEM 4. Submission of Matters to a Vote of SecurityHolders**

No matters were submitted to avote of security holders of the Company, through solicitation of proxies orotherwise, during the last quarter of 2004.

 

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**PART II**

**ITEM5. Market for the Company’s Common Equity and Related Stockholder Matters**

**Market Price and Dividends**

Ourcommon stock trades on The NASDAQ Stock Market under the symbol TNOX. The tablebelow provides the high and low sales prices of our common stock for theperiods indicated, as reported by the NASDAQ Stock Market.
| ** **                              | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------------|------------|----------|------------|---------|------------|
| **Year Ended December 31,  2003:** |       |     |       |    |       |
| First quarter                           |       | $        | 12.95      |    | $          | 8.03 |   |
| Second quarter                          |       | 19.75    |       | 11.92   |       |
| Third quarter                           |       | 22.74    |       | 15.61   |       |
| Fourth quarter                          |       | 20.00    |       | 13.59   |       |
| **Year  Ended December 31, 2004:** |       |     |       |    |       |
| First quarter                           |       | $        | 19.75      |    | $          | 14.02 |   |
| Second quarter                          |       | 19.07    |       | 15.31   |       |
| Third quarter                           |       | 18.34    |       | 13.25   |       |
| Fourth quarter                          |       | 18.19    |       | 13.69   |       |

 

On March 3, 2005, the last reported sale price ofour common stock on the NASDAQ Stock Market was $11.00. As of March 3,2005, there were 44,000,398 shares of common stock outstanding and 114shareholders of record of our common stock, one of which is Cede &Co., a nominee for Depository Trust Company (or DTC). All of the shares ofCommon Stock held by brokerage firms, banks and other financial institutions asnominees for beneficial owners are deposited into participant accounts at DTC,and therefore considered to be held of record by Cede & Co. as onestockholder.

We have never declared orpaid any cash dividends on our common stock and do not anticipate paying suchcash dividends in the foreseeable future. We currently anticipate that we willretain all of our future earnings for use in our research and productdevelopment activities and for general corporate purposes. Any determination topay dividends in the future will be at the discretion of our Board of Directorsand will depend upon our results of operations, financial condition and otherfactors as the Board of Directors, in its discretion, deems relevant.

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**ITEM 6. Selected Financial Data**

The information below was derived from the auditedconsolidated financial statements included in this report and in reports wehave previously filed with the Securities and Exchange Commission (SEC). This informationshould be read together with those consolidated financial statements and thenotes to the consolidated financial statements. These historical results arenot necessarily indicative of the results to be expected in the future.
| ** **                                                      | ** ** | **Year Ended December 31,**                         | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                      | ** ** | **(In thousands, except per share data)** | ** ** |
| **STATEMENT OF OPERATIONS DATA:**                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenues                                                        |       | $                                                                  | 20,506     |   | $ | 18,487 |   | $ | 560 |   | $ | 419 |   | $ | 12,748 |   |
| Research and development                                        |       | 27,200                                                             |       | 21,037 |   | 22,651 |   | 21,683 |   | 18,325 |   |
| General and  administrative                                     |       | 7,033                                                              |       | 7,337 |   | 10,677 |   | 8,349 |   | 7,683 |   |
| Restructuring  charge                                           |       | —                                                             |       | — |   | (268 | ) | 3,860 |   | — |   |
| Total operating  costs and expenses                             |       | 34,233                                                             |       | 28,374 |   | 33,060 |   | 33,892 |   | 26,008 |   |
| Loss from  operations                                           |       | (13,727                                                            | )          | (9,887 | ) | (32,500 | ) | (33,473 | ) | (13,260 | ) |
| Other income, net                                               |       | 3,437                                                              |       | 5,021 |   | 6,478 |   | 12,096 |   | 13,128 |   |
| Loss before  income taxes                                       |       | (10,290                                                            | )          | (4,866 | ) | (26,022 | ) | (21,377 | ) | (132 | ) |
| Benefit  (provision) of income taxes                            |       | —                                                             |       | 228 |   | — |   | — |   | (915 | ) |
| Net loss                                                        |       | $                                                                  | (10,290    | ) | $ | (4,638 | ) | $ | (26,022 | ) | $ | (21,377 | ) | $ | (1,047 | ) |
| Net loss per  share—basic and diluted                      |       | $                                                                  | (0.23      | ) | $ | (0.11 | ) | $ | (0.59 | ) | $ | (0.49 | ) | $ | (0.03 | ) |
| Shares used in computing  loss per share—basic and diluted |       | 44,020                                                             |       | 43,979 |   | 43,911 |   | 44,010 |   | 40,258 |   |
|                                                                 |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                 | ** ** | **December 31,**   | ** ** |
|--------------------------------------------|------------|-------------------------|------------|
| ** **                                 | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                 | ** ** | **(In thousands)** | ** ** |
| **BALANCE  SHEET DATA:**                   |       |                    |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and investments(1) |       | 202,511                 |       | $ | 227,434 |   | $ | 227,990 |   | $ | 261,102 |   | $ | 275,921 |   |
| Working capital                            |       | 164,425                 |       | 154,566 |   | 127,592 |   | 198,092 |   | 175,309 |   |
| Total assets                               |       | 238,553                 |       | 251,856 |   | 251,211 |   | 277,534 |   | 290,978 |   |
| Notes payable                              |       | 5,000                   |       | 15,000 |   | 15,000 |   | 10,000 |   | 10,000 |   |
| Accumulated  deficit                       |       | (93,835                 | )          | (83,545 | ) | (78,907 | ) | (52,885 | ) | (31,508 | ) |
| Total stockholders’  equity           |       | 224,198                 |       | 222,657 |   | 225,516 |   | 256,441 |   | 272,774 |   |
|                                            |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Includesrestricted cash and investments of $5,000, $15,967 and $14,441 in 2004, 2003and 2002, respectively.

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**ITEM7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

**Overview**

In 2004, we realized significant royalty revenue fromsales of Xolair. Xolair generated approximately $188.5 million in U.S. sales in2004 and is being distributed through five specialty pharmacies. It iscurrently labeled for treatment of adults and adolescents (12 years of age andabove) with moderate-to-severe persistent asthma who have a positive skin testor *in vitro* reactivity to a perennialaeroallergen and whose symptoms are inadequately controlled with inhaledcorticosteroids. Xolair has been shown to decrease the incidence of asthmaexacerbations in these patients. Safety and efficacy have not been establishedin other allergic conditions. Clinical trials to test the safety and efficacyof Xolair to treat pediatric asthma patients and peanut allergy patients areunder way.

In 2004, we recorded royalty revenue of $13.3 millionfrom sales of Xolair. Under our collaboration agreements with Genentech andNovartis, we receive royalties on the net sales of Xolair and will share inNovartis’ net profits from sales of Xolair in the United States. Over the nextseveral years, we expect our principal revenues will be royalties andprofit-sharing payments relating to sales of Xolair. We have estimated that,after giving effect to payments to our former attorneys, the blended rate ofour net royalty and profit sharing receipts will be in the range of 8% to 12%of net worldwide sales of Xolair.

During 2004, we initiated a Phase 2 clinical trial forour development product, TNX-355. Enrollment of this 48-week three-arm,double-blind, placebo-controlled study, was completed as of the date of thisreport. We expect to report interim 24-week data from the clinical trial in thefourth quarter of 2005 and have begun planning for a Phase 3 clinical trial ofthe product. We also advanced one investigational product, TNX-650, intopreclinical development in 2004. We anticipate filing an Investigational NewDrug application with the FDA for TNX-650 for the indication of inflammatorydisease by late 2005. In addition, we accelerated the advancement of TNX-717for osteoporosis through the research process by identifying a lead antibody. Weare now in the process of humanizing the antibody and anticipate moving TNX-717into preclinical proof-of-concept testing in 2005.

Our development pipeline has three additionalinvestigational therapies in research, and we are evaluating several othercompounds. During 2004, we also made a strategic decision to broaden ourresearch focus to include oncology. We have in-house scientific expertise inoncology and one of our investigational therapies in research has potential asan oncology therapy. There is also significant potential for oncology researchcollaborations for us in Houston, with several Texas Medical Centerinstitutions nearby.

Operationally, wesignificantly expanded our manufacturing capacity by agreeing in December 2004to assume the long-term lease of a biologics manufacturing facility in SanDiego, California. Biogen IDEC was the previous tenant under the lease, and wealso agreed to acquire manufacturing equipment with a 5,500-liter productioncapacity in the facility from Biogen IDEC, together with documentation, forapproximately $5.6 million. This transaction is an important step toward ourachieving full integration. We expect the facility will enable us tomanufacture clinical material for our current pipeline products and allow forthe expansion of our pipeline through in-licensing or acquisition opportunities.It should also give us better control over producing multiple clinical drugs. Thetransaction, including assumption of the lease, closed in January 2005.

**Critical Accounting Policies**

***Use ofEstimates***

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and footnotes thereto. Actualresults may differ from those estimates.

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***RevenueRecognition***

Revenues from developmentagreements include payments for milestone achievements and sponsored researchand development costs. Milestone payments are received under best effortscontracts and are not refundable. They are recognized as revenue when themilestones are achieved and there are no remaining performance obligations. Revenuesfor sponsored research and development are recognized as revenue as we completeour obligations related to such activities. Any revenue contingent upon futureperformance is deferred and recognized as the performance is completed. Underour collaboration agreements with Genentech and Novartis, we receive a royaltyon the net sales of Xolair worldwide and share in Novartis’ net profits fromXolair sales in the United States. Royalty revenue is recorded monthly based oncontractual terms and information provided by Genentech and Novartis. Royaltiesare reconciled and adjusted if actual results differ from those previouslyreported to us. Revenues recognized are net of certain milestone and othercredits and amounts due to our former attorneys under an arbitration award.

***Researchand Development***

Research and developmentexpenses consist of direct costs and indirect overhead costs, including facilitiescosts, salaries and related benefit costs and material and supply costs. Expensesmay also include upfront fees and milestones paid to licensors andcollaborative partners. Such amounts are expensed as incurred. Research anddevelopment costs also include estimates for clinical trial costs, which arebased on patient enrollment and clinical trial progress. Actual costs maydiffer from estimates.

***Recent Accounting Pronouncement***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS 123 (Revised) “Share-Based Payment.”  The statement eliminates the ability toaccount for stock-based compensation using APB 25 and requires suchtransactions to be recognized as compensation expense in the statement ofoperations based on their fair values on the date of the grant, with thecompensation expense recognized over the period in which an employee isrequired to provide service in exchange for the stock award. Tanox will adoptthis statement on July 1, 2005 using a modified prospective application. Assuch, the compensation expense recognition provisions will apply to new awardsand to any awards modified, repurchased or cancelled after the adoption date. Additionally,for any unvested awards outstanding at the adoption date, we will recognizecompensation expense over the remaining vesting period.

We have begun but have not yet completed, evaluatingthe impact of adopting SFAS 123 (Revised) on our results of operations. Wecurrently determine the fair value of stock-based compensation using aBlack-Scholes option pricing model. In connection with evaluating the impact ofadopting SFAS 123 (Revised), we are also considering the potentialimplementation of different valuation models to determine the fair value ofstock-based compensation, although no decision has yet been made.

However, we believe theadoption of SFAS 123 (Revised) will have a material impact on our results ofoperations, regardless of the valuation technique used. If we were to continueto use a Black-Scholes option pricing model consistent with our currentpractice, the adoption of SFAS 123 (Revised) on July 1, 2005, using amodified prospective application, is expected to result in additionalcompensation expense of $4.0 to $5.0 million before income taxes for the yearended December 31, 2005.

**Results of Operations**

This discussion of ourResults of Operations contains forward-looking statements regarding revenue,research and development expenses and general and administrative expenses. Fora discussion of the risks and uncertainties associated with our forward lookingprojections, please see the “Factors That May Affect Our Future Results”section in this Form 10-K.

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***Years Ended December 31, 2004, 2003 and 2002***

*TotalRevenues.  *Revenues consist of the following:
| ** **                                                                 | ** ** | **For the year ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                 | ** ** | **(in thousands)**                                      | ** ** |
| Development  agreements and license fees, net of arbitration award in 2003 |       | $                                                            | 3,725      |   | $ | 13,204 |   | $ | 560 |   |
| Development  agreements and license fees from related party                |       | 3,470                                                        |       | 3,399 |   | — |   |
| Royalties, net of  arbitration award                                       |       | 13,240                                                       |       | 1,878 |   | — |   |
| Royalties from  related party, net of arbitration award                    |       | 71                                                           |       | 6 |   | — |   |
| **Total Revenues**                                                         | ** ** | **$**                                                        | **20,506** | ** ** | **$** | **18,487** | ** ** | **$** | **560** | ** ** |

 

Development agreement revenue includes reimbursementby Genentech and Novartis of selected clinical trial costs incurred for TNX-901.Current year development agreement revenue also includes $6.6 million receivedunder the terms of the Tripartite Collaboration Agreement among Novartis,Genentech and Tanox dated February 25, 2004, representing reimbursement byGenentech and Novartis of a portion of the TNX-901 costs incurred by Tanox inprevious years. Development agreement revenue for 2003 included $20.0 millionin milestone revenue associated with the FDA approval of Xolair in June 2003per our collaboration agreements with Novartis and Genentech. This revenue wasreduced by $5.3 million which was paid to our former attorneys under thearbitration ruling. Royalty revenue of $13.3 million in 2004 and $1.9 millionin 2003 from the sale of Xolair was net of $1.5 million in 2004 and $209,000 in2003, due to our former attorneys under the arbitration award.

*Research and Development Expenses.  *Researchand development expense consists of costs incurred for product development anddiscovery research programs. The major components of research and developmentcosts include salaries and employee benefits, clinical trial expenses, clinicalmanufacturing costs, consulting and other third-party costs, supplies and materials,equipment depreciation and allocations of various overhead and facilitiescosts.

Ourresearch and development activities can be divided into clinical stageprograms, which currently include TNX-355 and TNX-901 (another anti-IgEantibody that had been studied in peanut allergy and for which a limitedinvestigator-sponsored extension study is continuing), and research andpreclinical stage programs, which include TNX-650, for inflammatory disease,TNX-717 for the treatment of osteoporosis, TNX-668 for systemic lupusErythematosus, TNX-558 for inflammatory disease and other discovery andexploratory research projects. For the years ended December 31, 2004, 2003and 2002, costs associated with research and development programs, includingoverhead allocation, approximated the following:
| ** **                                   | ** ** | **For the year ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                                      | ** ** |
| Clinical stage  programs                     |       | $                                                            | 18,698     |   | $ | 15,386 |   | $ | 17,306 |   |
| Research and  preclinical stage programs     |       | 8,502                                                        |       | 5,651 |   | 5,345 |   |
| **Total research and development  expenses** | ** ** | **$**                                                        | **27,200** | ** ** | **$** | **21,037** | ** ** | **$** | **22,651** | ** ** |

 

Research and development expenses increased $6.2million in 2004 from 2003 due to expenses associated with TNX-355 developmentactivities and increased spending for preclinical stage programs. Research anddevelopment expenses decreased in 2003 compared to 2002 by $1.6 million. Thedecrease was primarily due to the winding down of TNX-901 development which waspartially offset by increased TNX-355 development activities.

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*Generaland Administrative Expenses.  *For the years ended December 31,2004, 2003 and 2002, the cost associated with general and administrativeactivities approximate the following:
| ** **                               | ** ** | **For the year ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                               | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                               | ** ** | **(in thousands)**                                      | ** ** |
| **General  and administrative expenses** | ** ** | **$**                                                        | **7,033**  | ** ** | **$** | **7,337** | ** ** | **$** | **10,677** | ** ** |
|                                          |            |                                                              |            |  |  |  |  |  |  |  |

 

General and administrative expenses for the yearsended December 31, 2004 decreased $304,000 from 2003, while 2003 versus2002 decreased by $3.3 million due to reduced litigation spending and reducedpersonnel related costs. This was partially offset by increased directors andofficers’ insurance expense.

*Restructuring Charge*.   In June 2001,Tanox recorded a $3.9 million restructuring charge associated with the closureof the research operations of Tanox Pharma B.V. During 2002, the estimated costto complete these activities was reduced by $268,000. Tanox completed therestructuring activities in April 2003.

*Other Income (Expense)*.   For the years ended December 31,2004, 2003 and 2002, other income (expense) approximated the following:
| ** **                  | ** ** | **For the year ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                  | ** ** | **(in thousands)**                                      | ** ** |
| **Other  Income (Expense)** | ** ** | **$**                                                        | **3,437**  | ** ** | **$** | **5,021** | ** ** | **$** | **6,478** | ** ** |
|                             |            |                                                              |            |  |  |  |  |  |  |  |

 

Other income has decreased during the last three yearsprincipally due to reduced interest income resulting from lower average interestrates and lower amounts available for investment. In 2003, other expense alsoincludes a loss of $348,000 on the sale of assets associated with closing ourTaiwan office in May 2003. In 2002, higher interest income was offset by a$784,000 other-than-temporary decline in the fair value of anavailable-for-sale investment.

*Income Tax Benefit.  *Duringthe year ended December 31, 2003, we received a refund related toAlternative Minimum Taxes paid in 1996 and 1997 which we recorded as a credit (benefit)to our income tax provision. There was no provision for income taxes in 2004,2003 or 2002, due to pre-tax losses of $10.3 million, $4.9 million and $26.0million, respectively. These pre-tax losses generated a tax benefit, which wasfully offset by an increase in Tanox’s valuation allowance.

*Net Loss*.   Thenet loss increased to $10.3 million in 2004 or $0.23 per share, as compared to$4.6 million or $0.11 per share in 2003 and decreased from $26.0 million or$0.59 per share in 2002.

**Liquidity and Capital Resources**

We have financed our operations since inceptionprimarily through sales of equity securities, collaboration and grant revenues,interest income, equipment financing agreements and, beginning in 2003, royaltyrevenue related to sales of Xolair. During the year ended December 31,2000, we sold 8,568,000 shares of common stock at $28.50 per share in aninitial public offering and received net proceeds of $225.8 million.

Cash, cash equivalents and investments decreased by$24.9 million for the year ended December 31, 2004 to $202.5 million from$227.4 million at December 31, 2003. This decrease in funds was primarilydue to funding operating activities and capital expenditures as well as therelease from escrow of $9.7 million to our former attorneys, partially offsetby royalty revenue and the $6.6 million in development revenue received underthe terms of the three-party collaboration agreement with Genentech andNovartis as a reimbursement of a portion of TNX-901 development costs incurredin previous years.

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Net cash used in operatingactivities was $17.0 million for the year ended December 31, 2004 comparedto net cash provided by these activities of $349,000 for the year ended December 31,2003. The 2004 use of cash was comprised mainly of a net loss of $10.3 million,an increase in receivables and other assets of $5.3 million and a decrease incurrent liabilities of $4.1 million, the majority of which was related to therelease of escrowed funds to our former attorneys in connection with theaccrued arbitration award. In 2003, cash provided by operating activities wascomprised mainly of a net loss of $4.6 million and an increase in currentliabilities of $3.5 million, related primarily to accrued litigation costs.

Net cash provided byinvesting activities was $292,000 for the year ended December 31, 2004compared to $4.1 million for the year ended December 31, 2003. In 2004,restricted cash decreased by $5.5 million, due to the release of escrowed fundsin connection with the accrued arbitration award. Additionally, investments,net of maturities and purchases, decreased by $3.7 million and $8.9 million wasinvested in property and equipment. For 2003, investments, net of maturitiesand purchases, decreased by $12.5 million. This was partially offset by anincrease in restricted cash of $5.7 million due to the maturity of a restrictedinvestment.

Net cash provided byfinancing activities was $551,000 for the year ended December 31, 2004compared to $1.2 million for the same period in 2003. These inflows of cashresulted from stock option exercises.

Tanox entered into amanufacturing and supply agreement in July 2004 to have a third partymanufacture and supply Tanox’s TNX-355 for Phase 3 clinical trials andpotential product launch. Payments due to this third party under the agreementare based on the achievement of manufacturing deliverables and quantities to bemanufactured based on the size of clinical trials. Under the terms of theagreement, if Tanox were to terminate the agreement before or upon completionof the technology transfer deliverable (Research Stage), it would be requiredto pay a cancellation fee equal to twenty-five percent of the un-invoicedportion of the remaining process development program balance, as defined in theagreement.

Tanox and the third partymanufacturer began discussions in the fourth quarter of 2004 related torevisions to the agreement because we determined that we would produce TNX-355for Phase 3 clinical trials in a manufacturing facility on which we assumed thelease in January 2005. In February 2005, a letter agreement with thethird party manufacturer was reached to suspend all provisions of the agreementfor a period to be determined by us, but not to exceed 30 months. We plan toresume production of TNX-355 under this agreement on or before August 30,2007.

Under the terms of theletter agreement, Tanox will pay a total of $1.7 million of which $340,000represents a cancellation fee and the remaining $1,360,000 may be creditedagainst future work performed by the third party manufacturer, subject tocertain limitations. We will also pay $275,000 for work performed by the thirdparty manufacturer as of December 31, 2004. The total amount accrued as ofDecember 31, 2004 related to this transaction was $615,000 as research anddevelopment expense.

We were engaged inlitigation in connection with a fee dispute with the law firms that representedus in litigation with Genentech relating to, among other things, theintellectual property rights surrounding the development of anti-IgE technology.In 2003, an arbitration panel issued an award entitling the attorneys toreceive (1) approximately $3.5 million, including interest, (2) paymentsranging from 331¤3%to 40% of the future milestone payments, in excess of the first $1 million, wewould receive from Genentech following product approval, and (3) 10% ofthe royalties that we would receive on all sales of certain anti-IgE products,including Xolair. During the appealsprocess, we were required to place amounts in escrow to secure payment of theaward, and had escrowed $9.7 million with the Harris County District Court asof December 31, 2003. These funds were released to the former attorneys inFebruary 2004. The payment due to the attorneys in the amount of 10% ofthe royalties we receive on Xolair sales is required to be paid within 30 daysof the end of each calendar quarter in which the royalty payments are receivedby Tanox.

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On February 25, 2004, Tanox, Genentech andNovartis entered into a Tripartite Collaboration Agreement to settle all thenoutstanding litigation and arbitrations among the parties and to finalize thedetailed terms of the three-party collaboration, begun in 1996, to develop andcommercialize certain anti-IgE antibodies, including Xolair and TNX-901. Underthe terms of the three-party collaboration agreement, Genentech and Novartiseach reimbursed Tanox $3.3 million for a portion of its TNX-901 developmentcosts, and Tanox relinquished any rights to manufacture Xolair and, inexchange, will receive payments tied to the quantity of Xolair produced.

Tanox and Novartis also entered into an Amended andRestated Development and Licensing Agreement in February 2004. From 1994through 1998, Novartis advanced Tanox $10.0 million, pursuant to a loanagreement, to finance the construction of our pilot plant manufacturingfacility. Under the terms of the Amended and Restated Development and LicensingAgreement, the principal and accrued interest of $10,742,000 were forgiven infull by Novartis and recorded by Tanox as a capital infusion since Novartis isa related party for accounting purposes.

In September 2002, we entered into a $16.0million Revolving Line of Credit Note Agreement with a bank. Under the terms ofthe agreement, Tanox may secure advances up to the aggregate principal amountof $16.0 million, the proceeds of which can be used to finance the purchase ofproperty, plant and equipment. The outstanding principal balance is payable infull on September 27, 2006, and advances bear interest at the lesser ofthe Prime Rate or LIBOR, the London Interbank Offered Rate, plus 1%. Accruedinterest is payable on the last day of each month. As of December 31,2004, we had borrowed $5.0 million under the Agreement.

During the year ended December 31, 2004, weinvested approximately $8.9 million in equipment and facility improvements.

Pursuant to a Lease Assignment and Asset PurchaseAgreement dated December 9, 2004, between Biogen IDEC and Tanox, on January 10,2005, we acquired from Biogen IDEC certain manufacturing, process developmentand QA/QC equipment, related documentation and furniture and fixtures housed ina 76,000 square foot leased facility located in San Diego, California. We alsoagreed to assume the obligations of Biogen IDEC under the triple net lease forthe facility, which extends until October 2011, with two five-yearextension options. The lease payments for 2005 will be $3.8 million and willincrease annually over the term of the lease, including extension periods, at arate of approximately 4%. Upon closing of the transaction on January 10,2005, we paid Biogen IDEC approximately $5.6 million for the assets. As partialconsideration for Tanox’s agreement to the extension of the lease term to September 30,2011 and assuming Tanox is not then in default under the lease agreement,Biogen IDEC agreed to make two payments to us, each in the amount ofapproximately $2.4 million, on September 30, 2007 and November 30,2008. The total future lease obligation of Tanox for this lease assignmentthrough 2011, net of the Biogen IDEC payments, should approximate $24.6million.

Thefollowing table represents Tanox’s contractual obligations as of December 31,2004:
| ** **                       | ** ** | **Payments due by period (in thousands)** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                                         | ** ** | **Total** | ** ** | **Less than 1 year** | ** ** | **1 to 3 years** | ** ** | **3 to 5 years** | ** ** | **More than 5 years** | ** ** |
| Operating Leases*                |       | $                                                                  | 117        |   |   | $ | 79 |   |   |   | $ | 38 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Notes Payable                    |       | 5,000                                                              |       |   | — |   |   |   | 5,000 |   |   |   | — |   |   |   | — |   |   |
| Purchase obligations**           |       | 1,700                                                              |       |   | 850 |   |   |   | 850 |   |   |   | — |   |   |   | — |   |   |
| Total                            |       | $                                                                  | 6,817      |   |   | $ | 929 |   |   |   | $ | 5,888 |   |   |   | $ | — |   |   |   | $ | — |   |   |
|                                  |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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*                    Thisdoes not include the lease assignment and asset purchase dated December 9,2004 between Biogen IDEC and Tanox signed on January 10, 2005 which willbe a total commitment of $24.6 million through 2011.

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**             Purchase obligationsincludes commitments related to manufacturing operations and $340,000 of thisamount is included in research and development expenses and accrued liabilitiesat December 31, 2004.

Our current and anticipated development projectsrequire substantial additional capital to complete. We do not expect togenerate positive cash flow from operations until at least 2007 because weanticipate that the amount of cash we need to fund operations, includingresearch and development, manufacturing and other costs, and for capitalexpenditures, will grow in the future as our projects move from research toclinical development to commercialization. We may make acquisitions ofbusinesses or intellectual property assets and also expect that we will need toexpand our clinical development, manufacturing capacity, facilities, businessdevelopment and marketing activities to support the future development of ourprograms. Based on cash projections, we expect that cash on hand and revenuefrom operations will be sufficient to fund our existing operations for at leastthe next four years. However, our future capital needs will depend on manyfactors, including the continued successful commercialization of Xolair,progress in our research and development activities, commercializationactivities, the costs and magnitude of product or technology acquisitions, thecost of preparing, filing, prosecuting, maintaining and enforcing patent claimsand other intellectual property rights, competing technological and marketdevelopments, changes in or terminations of existing collaboration andlicensing arrangements, establishing additional collaboration and licensingarrangements, potential merger and acquisition activities, and manufacturingscale-up costs and marketing activities, if we undertake those activities. Consequently,we may need to raise additional funds, and we may issue additional shares ofcommon stock or other equity securities.

We do not haveexternal committed sources of funding and we cannot assure that we will be ableto obtain additional funds on acceptable terms, if at all. If adequate fundsare not available, we may be required to:

·       delay,reduce the scope of or eliminate one or more of our programs;

·       obtainfunds through arrangements with collaboration partners or others that mayrequire us to relinquish rights to technologies, product candidates or productsthat we would otherwise seek to develop or commercialize ourselves; or

·       licenserights to technologies, product candidates or products on terms that are lessfavorable to us than might otherwise be available.

**ITEM 7A. Quantitative and Qualitative Disclosures AboutMarket Risk**

We are exposed to a variety of risks, includingchanges in interest rates. In the normal course of business, we haveestablished policies and procedures to manage these risks.

*Foreign Currency Exchange Rates*.   Wewere subject to foreign currency exchange risk because we conducted operationsthrough two foreign subsidiaries prior to the closing of Tanox Pharma B.V. andour Taiwan office in 2003.

*Interest Rate Risk.  *Cash,cash equivalents and investments were approximately $202.5 million (includingthe restricted cash of $5.0 million) at December 31, 2004. These assetswere primarily invested in investment grade corporate bonds and commercialpaper with maturities of less than three years, which we have the ability andintent to hold to maturity. We do not invest in derivative securities. Althoughour portfolio is subject to fluctuations in interest rates and marketconditions, no gain or loss on any security would actually be recognized inearnings unless we sell the asset. In addition, our bank line of credit isbased on a premium over LIBOR. As such, if general interest rates increase, ourinterest costs will increase.

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**ITEM 8. Financial Statements and Supplementary Data**

**Tanox, Inc.**

**Index to Consolidated Financial Statements**
|                                                                                                                         | ** ** | **PAGE** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of  Independent Registered Public Accounting Firm                                                                |       |     | 38         |   |   |
| Report of Independent Registered Public Accounting  Firm                                                                |       |     | 39         |   |   |
| Consolidated Balance Sheets as of December 31,  2004 and 2003                                                      |       |     | 40         |   |   |
| Consolidated Statements of Operations and  Comprehensive Loss for the Years Ended December 31, 2004, 2003 and 2002 |       |     | 41         |   |   |
| Consolidated Statements of Stockholders’ Equity for  the Years Ended December 31, 2004, 2003 and 2002.        |       |     | 42         |   |   |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2004, 2003 and 2002                        |       |     | 43         |   |   |
| Notes to  Consolidated Financial Statements.                                                                            |       |     | 44         |   |   |

 

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**Report of Independent Registered Public Accounting Firm**

To the Board of Directors andStockholdersof Tanox, Inc.

We have audited the accompanying consolidated balancesheets of Tanox, Inc. and subsidiaries (the Company) as of December 31,2004 and 2003, and the related consolidated statements of operations andcomprehensive loss, stockholders’ equity and cash flows for each of the threeyears in the period ended December 31, 2004. These financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Tanox, Inc. as of December 31, 2004 and 2003, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Tanox, Inc.’s internal control over financial reportingas of December 31, 2004, based on criteria established in InternalControl-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated December 31,2004, expressed an unqualified opinion thereon.

/s/ Ernst & YoungLLP

Houston, TexasMarch 5, 2005

38

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**Report of Independent Registered Public Accounting Firm**

To the Board of Directors andStockholdersof Tanox, Inc.

We have audited management’s assessment, included inthe accompanying Management Report on Internal Control over FinancialReporting, that Tanox, Inc. (Tanox) maintained effective internal controlover financial reporting as of December 31, 2004, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (the COSO criteria). Tanox’smanagement is responsible for maintaining effective internal control overfinancial reporting for its assessment of the effectiveness of internal controlover financial reporting. Our responsibility is to express an opinion onmanagement’s assessment and an opinion on the effectiveness of the company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsider necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

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

In our opinion, management’s assessment that Tanoxmaintained effective internal control over financial reporting as of December 31,2004, is fairly stated, in all material respects, based on the COSO criteria. Also,in our opinion, Tanox, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31,2004, based on the COSO criteria.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of Tanox, Inc. and subsidiaries as of December 31,2004 and 2003, and the related consolidated statements of operations,stockholder’s equity and cash flows for each of the three years in the periodended December 31, 2004 of Tanox, Inc. and our report dated March 5,2005 expressed an unqualified opinion thereon.

/s/ Ernst & YoungLLP

Houston, TexasMarch 5, 2005

39

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**TANOX, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except shares and per share data)**
| ** **                                                                                                                                                                                                                       | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **ASSETS**                                                                                                                                                                                                                       |       |                  |       |   |   |
| CURRENT  ASSETS:                                                                                                                                                                                                                 |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                        |       | $                     | 5,284      |   | $ | 21,450 |   |
| Restricted cash                                                                                                                                                                                                                  |       | 5,000                 |       | 10,536 |   |
| Short-term investments,  including restricted amounts of $5,431 in 2003                                                                                                                                                          |       | 152,960               |       | 131,611 |   |
| Interest receivable                                                                                                                                                                                                              |       | 2,149                 |       | 3,002 |   |
| Accounts receivable                                                                                                                                                                                                              |       | 6,049                 |       | 1,706 |   |
| Accounts receivable from  related party                                                                                                                                                                                          |       | 44                    |       | 184 |   |
| Prepaid expenses and other                                                                                                                                                                                                       |       | 2,294                 |       | 276 |   |
| Total current assets                                                                                                                                                                                                             |       | 173,780               |       | 168,765 |   |
| LONG-TERM INVESTMENTS                                                                                                                                                                                                            |       | 39,267                |       | 63,837 |   |
| PROPERTY, PLANT AND EQUIPMENT,  NET                                                                                                                                                                                              |       | 25,506                |       | 19,205 |   |
| OTHER ASSETS                                                                                                                                                                                                                     |       | —                |       | 49 |   |
| Total assets                                                                                                                                                                                                                     |       | $                     | 238,553    |   | $ | 251,856 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                   |       |                  |       |   |   |
| CURRENT  LIABILITIES:                                                                                                                                                                                                            |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                                 |       | $                     | 2,399      |   | $ | 968 |   |
| Accrued liabilities                                                                                                                                                                                                              |       | 6,092                 |       | 3,390 |   |
| Accrued arbitration award                                                                                                                                                                                                        |       | 864                   |       | 9,841 |   |
| Total current liabilities                                                                                                                                                                                                        |       | 9,355                 |       | 14,199 |   |
| LONG-TERM LIABILITIES:                                                                                                                                                                                                           |       |                  |       |   |   |
| Note payable to bank                                                                                                                                                                                                             |       | 5,000                 |       | 5,000 |   |
| Note payable to related party                                                                                                                                                                                                    |       | —                |       | 10,000 |   |
| Total long-term liabilities                                                                                                                                                                                                      |       | 5,000                 |       | 15,000 |   |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                                       |       |                  |       |   |   |
| Preferred stock, $.01 par  value; 10,000,000 shares authorized;  none outstanding                                                                                                                                           |       | —                |       | — |   |
| Common stock, $.01 par value;  120,000,000 shares authorized;  44,531,998  and 44,470,446 shares issued in 2004 and 2003, respectively; 43,977,298  shares and 43,915,746 shares outstanding in 2004 and 2003, respectively |       | 445                   |       | 445 |   |
| Additional paid-in capital                                                                                                                                                                                                       |       | 322,671               |       | 311,324 |   |
| Treasury stock, at cost;  554,700 shares in 2004 and 2003                                                                                                                                                                        |       | (6,261                | )          | (6,261 | ) |
| Accumulated other  comprehensive income                                                                                                                                                                                          |       | 1,178                 |       | 694 |   |
| Accumulated deficit                                                                                                                                                                                                              |       | (93,835               | )          | (83,545 | ) |
| Total stockholders’ equity                                                                                                                                                                                                  |       | 224,198               |       | 222,657 |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                  |       | $                     | 238,553    |   | $ | 251,856 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

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**TANOX, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFOPERATIONS AND COMPREHENSIVE LOSS(In thousands, except per share data)**
| ** **                                                                        | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| REVENUES:                                                                         |       |                                                         |       |   |   |   |   |
| Development agreements and  licensing fees, net of arbitration award in 2003 |       | $                                                            | 3,725      |   | $ | 13,204 |   | $ | 560 |   |
| Development agreement with  related party                                         |       | 3,470                                                        |       | 3,399 |   | — |   |
| Royalties, net of arbitration  award                                              |       | 13,240                                                       |       | 1,878 |   | — |   |
| Royalties from related party,  net of arbitration award                           |       | 71                                                           |       | 6 |   | — |   |
| Total revenues                                                                    |       | 20,506                                                       |       | 18,487 |   | 560 |   |
| OPERATING COSTS AND EXPENSES:                                                     |       |                                                         |       |   |   |   |   |
| Research and development                                                          |       | 27,200                                                       |       | 21,037 |   | 22,651 |   |
| General and administrative                                                        |       | 7,033                                                        |       | 7,337 |   | 10,677 |   |
| Restructuring charge                                                              |       | —                                                       |       | — |   | (268 | ) |
| Total operating costs and  expenses                                               |       | 34,233                                                       |       | 28,374 |   | 33,060 |   |
| LOSS FROM OPERATIONS                                                              |       | (13,727                                                      | )          | (9,887 | ) | (32,500 | ) |
| OTHER INCOME (EXPENSES):                                                          |       |                                                         |       |   |   |   |   |
| Interest income                                                                   |       | 3,754                                                        |       | 5,959 |   | 7,865 |   |
| Interest expense                                                                  |       | (166                                                         | )          | (451 | ) | (595 | ) |
| Other, net                                                                        |       | (151                                                         | )          | (487 | ) | (792 | ) |
| Total other income                                                                |       | 3,437                                                        |       | 5,021 |   | 6,478 |   |
| LOSS BEFORE INCOME TAX BENEFIT                                                    |       | (10,290                                                      | )          | (4,866 | ) | (26,022 | ) |
| Income tax benefit                                                                |       | —                                                       |       | 228 |   | — |   |
| NET LOSS                                                                          |       | $                                                            | (10,290    | ) | $ | (4,638 | ) | $ | (26,022 | ) |
| NET LOSS PER SHARE—Basic and  diluted                                        |       | $                                                            | (0.23      | ) | $ | (0.11 | ) | $ | (0.59 | ) |
| SHARES USED IN COMPUTING NET  LOSS PER SHARE—  Basic and diluted             |       | 44,020                                                       |       | 43,979 |   | 43,911 |   |
| COMPREHENSIVE LOSS:                                                               |       |                                                         |       |   |   |   |   |
| Net loss                                                                          |       | $                                                            | (10,290    | ) | $ | (4,638 | ) | $ | (26,022 | ) |
| Foreign currency translation  adjustment                                          |       | —                                                       |       | (168 | ) | 84 |   |
| Unrealized gain on  available-for-sale securities                                 |       | 484                                                          |       | 694 |   | — |   |
| TOTAL  COMPREHENSIVE LOSS                                                         |       | $                                                            | (9,806     | ) | $ | (4,112 | ) | $ | (25,938 | ) |

 

The accompanying notes are anintegral part of these consolidated financial statements.

41

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**TANOX, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYFor the Years Ended December 31, 2004, 2003 and 2002(In thousands, except share data)**
| ** **                                                                             | ** ** | ** **            | ** ** | ** **         | ** ** | ** **     | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|----------------|------------|--------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                                                             | ** ** | ** **            | ** ** | ** **         | ** ** | **Additional** | ** ** | ** **   | ** ** | ** **        | ** ** | **Other**       | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                                             | ** ** | **Common Stock** | ** ** | **Paid-in**        | ** ** | **Treasury**   | ** ** | **Deferred** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                             | ** ** | **Shares**            | ** ** | **Par Value** | ** ** | **Capital**    | ** ** | **Stock**    | ** ** | **Compensation**  | ** ** | **Income**      | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| BALANCES, December 31,  2001                                                      |       | 44,156,601            |       |               | $          | 442            |       |         | $          | 309,892           |       | $               | (1,009     | )                      |       | $          | (83        | ) |   |   | $ | 84 |   |   |   | $ | (52,885 | ) |   |   | $ | 256,441 |   |   |
| Exercise of stock options, net                                                         |       | 145,040               |       |               | 1          |           |       | 371          |       | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 372 |   |   |
| Repurchase of 474,700 shares of  common stock at cost                                  |       | —                |       |               | —     |           |       | —       |       | (5,252            | )          |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | (5,252 | ) |   |
| Amortization of deferred  compensation related to stock options                        |       | —                |       |               | —     |           |       | —       |       | —            |       |            | 83         |                   |       |       | —     |   |   |   | — |   |   |   | 83 |   |   |
| Stock option compensation to  non-employees                                            |       | —                |       |               | —     |           |       | (190         | )          | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | (190 | ) |   |
| Foreign currency translation  adjustment                                               |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | 84         |   |   |   | — |   |   |   | 84 |   |   |
| Net loss                                                                               |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | —     |   |   |   | (26,022 | ) |   |   | (26,022 | ) |   |
| BALANCES, December 31,  2002                                                      |       | 44,301,641            |       |               | $          | 443            |       |         | $          | 310,073           |       | $               | (6,261     | )                      |       | $          | —     |   |   |   | $ | 168 |   |   |   | $ | (78,907 | ) |   |   | $ | 225,516 |   |   |
| Exercise of stock options, net                                                         |       | 168,805               |       |               | 2          |           |       | 1,205        |       | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 1,207 |   |   |
| Stock option compensation to  non-employees                                            |       | —                |       |               | —     |           |       | 46           |       | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 46 |   |   |
| Foreign currency translation  adjustment                                               |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | (168       | ) |   |   | — |   |   |   | (168 | ) |   |
| Unrealized gain on available-for-sale security                                         |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | 694        |   |   |   | — |   |   |   | 694 |   |   |
| Net loss                                                                               |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | —     |   |   |   | (4,638 | ) |   |   | (4,638 | ) |   |
| BALANCES, December 31,  2003                                                      |       | 44,470,446            |       |               | $          | 445            |       |         | $          | 311,324           |       | $               | (6,261     | )                      |       | $          | —     |   |   |   | $ | 694 |   |   |   | $ | (83,545 | ) |   |   | $ | 222,657 |   |   |
| Exercise of stock options, net                                                         |       | 61,552                |       |               | —     |           |       | 551          |       | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 551 |   |   |
| Stock option compensation to  non-employees                                            |       | —                |       |               | —     |           |       | 54           |       | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 54 |   |   |
| Unrealized gain on available-for-sale securities                                       |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | 484        |   |   |   | — |   |   |   | 484 |   |   |
| Capital contribution from  forgiveness of loan principal and interest by related party |       | —                |       |               | —     |           |       | 10,742       |       | —            |       |            | —     |                   |       |       | —     |   |   |   | — |   |   |   | 10,742 |   |   |
| Net loss                                                                               |       | —                |       |               | —     |           |       | —       |       | —            |       |            | —     |                   |       |       | —     |   |   |   | (10,290 | ) |   |   | (10,290 | ) |   |
| BALANCES, December 31, 2004                                                       |       | 44,531,998            |       |               | $          | 445            |       |         | $          | 322,671           |       | $               | (6,261     | )                      |       | $          | —     |   |   |   | $ | 1,178 |   |   |   | $ | (93,835 | ) |   |   | $ | 224,198 |   |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements

42

 

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**TANOX, INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                           | ** ** | **For the Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                           | ** ** | **(In thousands)**                                      | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                               |       |                                                         |       |   |   |   |   |
| Net loss                                                                                             |       | $                                                            | (10,290    | ) | $ | (4,638 | ) | $ | (26,022 | ) |
| Adjustments to reconcile net loss to net cash provided  by (used in) operating activities— |       |                                                         |       |   |   |   |   |
| Depreciation and amortization                                                                        |       | 2,609                                                        |       | 2,231 |   | 2,057 |   |
| Impairment of  available-for-sale investment                                                         |       | —                                                       |       | — |   | 784 |   |
| Restructuring charge                                                                                 |       | —                                                       |       | — |   | (268 | ) |
| Compensation expense related to  stock options                                                       |       | 54                                                           |       | 46 |   | (107 | ) |
| Loss on sale of equipment                                                                            |       | 39                                                           |       | 399 |   | — |   |
| Other, net                                                                                           |       | —                                                       |       | 123 |   | 68 |   |
| Changes in operating assets and liabilities—                                                    |       |                                                         |       |   |   |   |   |
| Increase in receivables and  other assets                                                            |       | (5,319                                                       | )          | (1,316 | ) | (270 | ) |
| (Decrease) increase in current  liabilities                                                          |       | (4,102                                                       | )          | 3,504 |   | (129 | ) |
| Net cash provided by (used in)  operating activities                                                 |       | (17,009                                                      | )          | 349 |   | (23,887 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                |       |                                                         |       |   |   |   |   |
| Purchase of investments                                                                              |       | (249,139                                                     | )          | (171,237 | ) | (161,011 | ) |
| Maturities and sales of  investments                                                                 |       | 252,844                                                      |       | 183,710 |   | 72,231 |   |
| Additions to property, plant  and equipment                                                          |       | (8,949                                                       | )          | (2,638 | ) | (9,657 | ) |
| Decrease (increase) in  restricted cash                                                              |       | 5,536                                                        |       | (5,741 | ) | (4,795 | ) |
| Net cash provided by (used in)  investing activities                                                 |       | 292                                                          |       | 4,094 |   | (103,232 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                |       |                                                         |       |   |   |   |   |
| Proceeds from issuance of  common stock                                                              |       | 551                                                          |       | 1,207 |   | 372 |   |
| Advance on Line of Credit                                                                            |       | —                                                       |       | — |   | 5,000 |   |
| Purchase of treasury stock                                                                           |       | —                                                       |       | — |   | (5,252 | ) |
| Net cash provided by financing  activities                                                           |       | 551                                                          |       | 1,207 |   | 120 |   |
| IMPACT OF EXCHANGE RATES ON  CASH                                                                    |       | —                                                       |       | (168 | ) | 84 |   |
| INCREASE (DECREASE) IN CASH AND  CASH EQUIVALENTS                                                    |       | (16,166                                                      | )          | 5,482 |   | (126,915 | ) |
| CASH AND CASH EQUIVALENTS,  beginning of year                                                        |       | 21,450                                                       |       | 15,968 |   | 142,883 |   |
| CASH AND CASH EQUIVALENTS, end  of year                                                              |       | $                                                            | 5,284      |   | $ | 21,450 |   | $ | 15,968 |   |
| SUPPLEMENTAL DISCLOSURE OF CASH  FLOW INFORMATION:                                                   |       |                                                         |       |   |   |   |   |
| Capital contribution from  forgiveness of note payable by a related party                            |       | 10,000                                                       |       | — |   | — |   |
| Capital contribution from  forgiveness of interest by a related party                                |       | 742                                                          |       | — |   | — |   |
| Retirement of property and  equipment                                                                |       | —                                                       |       | — |   | 874 |   |
| Unrealized gain on  available-for-sale security                                                      |       | 484                                                          |       | 694 |   | — |   |
| Cash paid during the year for  interest                                                              |       | (127                                                         | )          | (115 | ) | (36 | ) |
| Cash received for Federal AMT refund                                                                 |       | —                                                       |       | 228 |   | — |   |

 

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

43

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements**

**1. ORGANIZATION AND BUSINESS**

Tanox, Inc. (Tanox or the Company) is abiotechnology company specializing in the discovery and development ofbiotherapeutics based on monoclonal antibody technology. The Company developsinnovative therapeutic agents for the treatment of immune-mediated diseases,inflammation, infectious diseases and cancer. Tanox was formerly known as TanoxBiosystems, Inc. and was incorporated as a Texas corporation on March 19,1986. Tanox was reincorporated in January 2000 as a Delaware corporation.

Tanox entered into a development and licensingagreement with the predecessor to Novartis Pharma AG (Novartis) in May 1990,in which Tanox and Novartis agreed to jointly develop, produce and marketcertain products for IgE-mediated diseases, including asthma and allergy. Tanoxreceived an initial milestone payment upon signing the agreement and hasreceived additional milestone payments and reimbursement of designated expenses.Under separate agreements, Novartis purchased 6,373,732 shares of Tanox commonstock and loaned Tanox $10.0 million for the construction of a pilotmanufacturing facility. Under the terms of the Amended and Restated Developmentand Licensing Agreement, dated February 25, 2004, the principal andaccrued interest on this loan were forgiven in full by Novartis and recorded byTanox as a capital infusion. Because the shares owned by Novartis representapproximately 14.5% of Tanox’s outstanding common stock at December 31,2004, Novartis is considered a related party in Tanox’s financial statements.

Tanox, Novartis and Genentech, Inc. (Genentech)entered into a binding agreement-in-principle (Three-Party Collaboration) in July 1996to combine their existing anti-IgE antibody programs into a cooperative effortto develop and commercialize selected anti-IgE antibodies. Xolair, whosetherapeutic effects have been validated in clinical trials in patientssuffering from allergic asthma, hay fever and perennial allergic rhinitis, isTanox’s most advanced product in development and is being developed under theThree-Party Collaboration. On June 20, 2003, Xolair was approved fortreating adults and adolescents with moderate to severe persistent asthma bythe Food and Drug Administration (FDA). Tanox receives royalty payments on netsales of Xolair pursuant to the Three-Party Collaboration, will participate inNovartis’ net profits on Xolair in the United States, will share net losses andnet profits with Novartis on the development and commercialization of Xolair incertain far East countries and will receive milestone payments upon theoccurrence of specified development and commercialization events. Tanox, Novartis and Genentech finalized thedetailed terms of the Three-Party Collaboration agreements in February 2004.

Tanox engages in researchand development activities which involve a high degree of risk and uncertainty.Tanox has not generated any revenues from product sales, only royalty anddevelopment revenue. The ability of Tanox to successfully develop, manufactureand market its products is dependent upon many factors. These factors couldinclude, but are not limited to, the need for additional financing, the abilityto maintain or obtain additional manufacturing capabilities and the ability todevelop or obtain sales and marketing capabilities or collaborativearrangements. Additional factors could include uncertainties as to patents andproprietary technologies, efficacy and safety of its products, competition,governmental regulations and regulatory approval.

44

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

**2. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

***Basis of Presentation***

The accompanyingconsolidated financial statements include the accounts of Tanox and its whollyowned subsidiaries, Tanox Pharma International, Inc., Tanox Pharma B.V.,TanAsia Pharma, Ltd., and Tanox West, Inc. Intercompany transactions andbalances are eliminated in consolidation. Tanox Pharma B.V. and TanAsia PharmaLtd. ceased to be subsidiaries in 2003.

***Use of Estimates***

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and footnotes thereto. Actualresults may differ from those estimates.

***Revenue Recognition***

Revenues from developmentagreements include payments for milestone achievements and sponsored researchand development costs. Milestone payments are received under best effortscontracts and are not refundable. They are recognized as revenue when themilestones are achieved and there are no remaining performance obligations. Revenuesfor sponsored research and development are recognized as revenue as the Companycompletes its obligations related to such activities. Any revenue contingentupon future performance is deferred and recognized as the performance iscompleted. Royalty revenue results from our collaboration agreements withGenentech and Novartis and is recorded monthly based on contractual termsapplied to reports provided by Genentech and Novartis. The Company receives aroyalty on the net sales of Xolair in the United States and Europe and sharesin the profits of Xolair sales by Novartis in the United States. Royalties arereconciled and adjusted if actual results differ from those previously reportedto us. Revenues recognized are reduced by certain milestone and other creditsand by certain amounts due to our former attorneys under an arbitration award.

***Cash Equivalents, Short-term and Long-term Investments***

Cash equivalents consistof highly-liquid investments with original maturities of three months or less. Managementdetermines the appropriate classification of its cash equivalents, short-terminvestments and long-term investments at the time of purchase. Investmentsconsist of investment grade corporate bonds, commercial paper, asset-backedsecurities, auction-rate securities and government agency securities withmaturities of less than three years from the balance sheet date. Certaininvestments are classified as held-to-maturity and carried at amortized cost inthe accompanying financial statements. The Company’s available-for-saleinvestments are stated at fair value based on the quoted market price of theinvestment. Unrealized gains and losses on available-for-sale investments arereported as other comprehensive income (loss), which is a separate component ofstockholders’ equity. For the year ended December 31, 2004, the fair valueof our available-for-sale investments increased by $484,000 and the increasewas recorded as an unrealized gain and is included as a component ofstockholders’ equity.

45

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

***Restricted Cash and Investments***

Tanox is required tomaintain restricted cash or investments to collateralize borrowings under itsRevolving Line of Credit Note Agreement. At December 31, 2004, Tanox hadrestricted cash of $5.0 million, and at December 31, 2003, Tanox hadrestricted cash and investments of $16.0 million.

***Fair Value of Financial Instruments***

Carrying amounts ofcertain of the Company’s financial instruments, including cash, cashequivalents and short-term investments, approximate fair value due to theirshort maturities. Based on borrowing rates currently available to the Companyfor loans with similar terms, the carrying value of the Company’s debtobligations approximates fair value.

***Concentration of Credit Risk***

Financial instruments thatpotentially subject the Company to concentrations of credit risk are primarilycash equivalents, investments in marketable securities and trade receivables. Cashequivalents and marketable securities consist of money market funds, taxablecommercial paper, asset-backed securities, corporate bonds with high creditquality auction-rate securities and U.S. government agency obligations. Allcash, cash equivalents and marketable securities are maintained with financialinstitutions that management believes are credit worthy. The Company’sinvestment policy, approved by the Board of Directors, limits the amount theCompany may invest in any one type of investment, thereby reducing credit riskconcentrations. Ninety nine percent and 90% of the Company’s receivables at December 31,2004 and 2003 and 81% and 75% of its revenues for the years ended December 31,2004 and 2003, respectively, are with Genentech, a large pharmaceutical companylocated in the United States. The Company has not experienced any significantcredit losses to date and, at December 31, 2004, management believes thatthe Company has no significant concentrations of credit risk.

***Property, Plant and Equipment***

Property,plant and equipment is carried at cost and depreciated on a straight-line basisover the estimated useful economic lives of the assets or, in the case ofleasehold improvements, over the shorter of the asset useful life or theremaining term of the lease. The estimated useful lives used in computingdepreciation are:
| ** **                       | ** ** | **Useful lives** |
|----------------------------------|------------|------------------|
| Buildings and  improvements      |       | 7 to  20 years   |
| Laboratory and office  equipment |       | 3 to  7 years    |
| Leasehold improvements           |       | 1  year          |
| Furniture and fixtures           |       | 5 to 7 years     |

 

When property is retired or otherwise disposed of, thecost and accumulated depreciation are removed from the accounts and anyresulting gain or loss is included in other income (expenses). Maintenance andrepair expenditures are charged to expense when incurred.

46

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

Property, plant and equipment balances at December 31,2004 and 2003 are summarized below (in thousands):
| **Property, Plant and Equipment  (at cost):** | ** ** | ** ** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Land                                                              |       | $          | 4,332      |     | $          | 4,332    |       |
| Building and improvements                                         |       | 16,714     |       | 8,005    |       |
| Laboratory and office  equipment                                  |       | 14,858     |       | 12,505   |       |
| Leasehold improvements                                            |       | —     |       | 144      |       |
| Furniture and fixtures                                            |       | 765        |       | 416      |       |
| Construction in progress                                          |       | 1,415      |       | 4,012    |       |
|                                                              |       | 38,084     |       | 29,414   |       |
| Less: Accumulated depreciation  and amortization                  |       | (12,578    | )          | (10,209  | )          |
| Net property, plant and equipment                                 |       | $          | 25,506     |     | $          | 19,205   |       |

 

***Impairment of Long-Lived Assets***

Management periodicallyreviews long-lived assets whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. If the carryingamount of the asset is greater than its undiscounted future operating cashflow, an impairment loss would be recognized.

***Research and Development***

Research and developmentexpenses consist of direct costs and indirect overhead costs, includingfacilities costs, salaries and related benefit costs and material and supplycosts. Expenses also include upfront fees and milestones paid to licensors andcollaborative partners. Such amounts are expensed as incurred. Research anddevelopment costs also include estimates for clinical trial costs, which arebased on patient enrollment and clinical trial progress. Actual costs maydiffer from estimates.

***Income Taxes***

Tanox accounts for incometaxes using the liability method prescribed by Statement of FinancialAccounting Standards (SFAS) No. 109, “Accounting for Income Taxes.”  Under this method, deferred income tax assetsand liabilities reflect the impact of temporary differences between thefinancial accounting and tax bases of assets and liabilities and are measuredusing the enacted tax rates and laws that will be in effect when the differencesare expected to reverse.

***Foreign Currency Transactions and Translations***

The balance sheet accounts of Tanox’s foreignsubsidiaries are translated into U.S. dollars at exchange rates in effect onreporting dates. Foreign currency translation adjustments are reflected inother comprehensive loss. Income statement items are translated at averageexchange rates in effect during the financial statement period. Gains andlosses resulting from foreign currency transactions denominated in currencyother than the functional currency are classified as other income /expenses.

TheCompany closed its office in Taiwan in May 2003 and dissolved TanAsia,Ltd., its Taiwan subsidiary, in 2003. In 2001, the Company closed itssubsidiary in the Netherlands, Tanox Pharma B.V., 

47

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

and in2003 transferred its ownership in the subsidiary to a third party. As a resultof the dissolution of these subsidiaries, a gain of $168,000, resulting fromforeign currency transactions, was recorded in 2003.

***Net Loss Per Share***

SFAS No. 128, “EarningsPer Share,” requires dual presentation of basic and diluted net loss per share(EPS). Basic EPS is computed by dividing net loss by the weighted averagenumber of shares of common stock outstanding during the year. Diluted EPS iscomputed in the same manner as basic EPS, except that diluted EPS reflects thepotential dilution that would occur if outstanding options and warrants wereexercised. Tanox incurred net losses for the years ended December 31,2004, 2003 and 2002; therefore, all options outstanding for each of the yearswere excluded from the computation of diluted EPS because they would have beenantidilutive.

***Segment Information***

The Company currentlyoperates in one business segment, that being the development andcommercialization of novel antibody drugs. The Company is managed and operatedas one business. The entire business is comprehensively managed by a singlemanagement team that reports to the Chief Executive Officer. The Company doesnot operate separate lines of business or separate business entities withrespect to its products or product candidates. Accordingly, the Company doesnot accumulate discrete financial information with respect to separate productareas and does not have separately reportable segments as defined by SFAS No. 131,“Disclosure about Segments of an Enterprise and Related Information.”

***Stock-Based Compensation***

As further discussed in Note 10, Tanox has fourstock-based compensation plans, which are accounted for under the recognitionand measurement provisions of Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees, and Related Interpretations.”  Under the intrinsic value method described inAPB Opinion No. 25, no compensation expense is recognized if the exerciseprice of the employee stock option equals the market price of the underlyingstock on the date of grant. Tanox recognized $54,000, $46,000 and ($107,000) ofstock-based compensation during the years ended December 31, 2004, 2003and 2002, respectively, which was related to Scientific Advisory Board Membersand non-employee stock options .

48

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

Assuming the compensation cost for the stock optionplans had been determined pursuant to the fair value method under SFAS No. 123“Accounting for Stock Based Compensation,” Tanox’s pro forma net loss wouldhave been as follows (in thousands, except per share data):
| ** **                             | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net loss—                         |       |                                       |       |   |   |   |   |
| As reported                            |       | $                                          | (10,290    | ) | $ | (4,638 | ) | $ | (26,022 | ) |
| Stock option compensation  Expense     |       | (5,282                                     | )          | (4,847 | ) | (4,745 | ) |
| Pro forma net loss                     |       | $                                          | (15,572    | ) | $ | (9,485 | ) | $ | (30,767 | ) |
| Loss per share—Basic and  diluted |       |                                       |       |   |   |   |   |
| As reported                            |       | $                                          | (0.23      | ) | $ | (0.11 | ) | $ | (0.59 | ) |
| Pro forma                              |       | $                                          | (0.35      | ) | $ | (0.22 | ) | $ | (0.70 | ) |

 

***Recent Accounting Pronouncement***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS 123 (Revised) “Share-Based Payment.”  The statement eliminates the ability toaccount for stock-based compensation using APB 25 and requires suchtransactions to be recognized as compensation expense in the statement ofoperations based on their fair values on the date of the grant, with thecompensation expense recognized over the period in which an employee isrequired to provide service in exchange for the stock award. The Company willadopt this statement on July 1, 2005 using a modified prospectiveapplication. As such, the compensation expense recognition provisions willapply to new awards and to any awards modified, repurchased or cancelled afterthe adoption date. Additionally, for any unvested awards outstanding at theadoption date, the Company will recognize compensation expense over theremaining vesting period.

The Company has begun but has not yet completed,evaluating the impact of adopting SFAS 123 (Revised) on its results ofoperations. The Company currently determines the fair value of stock-basedcompensation using a Black-Scholes option pricing model. In connection withevaluating the impact of adopting SFAS 123 (Revised), the Company is alsoconsidering the potential implementation of different valuation models todetermine the fair value of stock-based compensation, although no decision hasyet been made.

However, the Company does believe the adoption of SFAS123 (Revised) will have a material impact on its results of operations, regardlessof the valuation technique used. If the Company were to continue to use aBlack-Scholes option pricing model consistent with its current practice, theadoption of SFAS 123 (Revised) on July 1, 2005, using a modifiedprospective application, is expected to result in additional compensationexpense of $4.0 to $5.0 million before income taxes for the year ended December 31,2005.

***Reclassification***

Certain prior yearbalances have been reclassified in the financial statements for comparativepurposes. The Company reclassified $24.9 million of auction rate securitiesfrom cash and cash equivalents to short-term investments and reclassified $5.0million from held-to-maturity to available-for-sale based upon their statedmaturity date for the year ended December 31, 2003.

 

49

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

**3. INVESTMENTS**

Short-termand long-term investments at December 31, 2004 consist of the following(in thousands):
| ** **                                                        | ** ** | ** ** | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | **Estimated** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------------|------------|----------------|------------|---------------|------------|
| ** **                                                        | ** ** | **Book**   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**      | ** ** |
| ** **                                                        | ** ** | **Value**  | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value**     | ** ** |
| Asset-backed Securities:                                          |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | $          | 5,087      |           |       | $              | —     |          |       |   | (33 | ) |   | $ | 5,054 |   |
| Greater than 1 year and less than 3 years                         |       | 1,043      |       |           | —     |           |       |          | (4         | ) |   | 1,039 |   |
| Certificates of Deposit:                                          |       |       |       |           |       |           |       |          |       |   |   |   |   |
| Greater than 1 year and less than 3 years                         |       | 3,000      |       |           | —     |           |       |          | (30        | ) |   | 2,970 |   |
| Commercial Paper:                                                 |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 8,967      |       |           | —     |           |       |          | (3         | ) |   | 8,964 |   |
| Greater than 1 year and less than 3 years                         |       | 2,015      |       |           | —     |           |       |          | (20        | ) |   | 1,995 |   |
| Corporate Debt  Securities:                                       |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 70,302     |       |           | —     |           |       |          | (287       | ) |   | 70,015 |   |
| Greater than 1 year and less than 3 years                         |       | 2,541      |       |           | —     |           |       |          | (15        | ) |   | 2,526 |   |
| Euro Dollar Bonds:                                                |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 10,552     |       |           | —     |           |       |          | (48        | ) |   | 10,504 |   |
| Greater than 1 year and less than 3 years                         |       | 1,169      |       |           | —     |           |       |          | (17        | ) |   | 1,152 |   |
| Municipal Bonds:                                                  |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 2,925      |       |           | —     |           |       |          | (14        | ) |   | 2,911 |   |
| Government/Agency  Securities:                                    |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 17,407     |       |           | —     |           |       |          | (100       | ) |   | 17,307 |   |
| Greater than 1 year and less than 3 years                         |       | 29,500     |       |           | —     |           |       |          | (284       | ) |   | 29,216 |   |
| Total Securities  held to maturity                                |       | 154,508    |       |           | —     |           |       |          | (855       | ) |   | 153,653 |   |
| Available-for-sale  investments*                                  |       | 36,541     |       |           | 1,178      |           |       |          | —     |   |   | 37,719 |   |
| Total short- and  long-term investments at December 31, 2004 |       | $          | 191,049    |           |       | $              | 1,178      |          |       |   | $ | (855 | ) |   | $ | 191,372 |   |
|                                                                   |            |            |            |                |            |                |            |               |            |  |  |  |  |  |  |  |  |

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*                    For the yearended December 31, 2004, the fair value of our available-for-saleinvestments increased by $484,000 and an unrealized gain is included as acomponent of stockholders’ equity

50

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

Short-term and long-terminvestments at December 31, 2003 consist of the following (in thousands):
| ** **                                                        | ** ** | ** ** | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | **Estimated** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------------|------------|----------------|------------|---------------|------------|
| ** **                                                        | ** ** | **Book**   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**      | ** ** |
| ** **                                                        | ** ** | **Value**  | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value**     | ** ** |
| Negotiable CD’s:                                             |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | $          | 3,035      |           |       | $              | 17         |          |       |   | — |   |   | $ | 3,052 |   |
| Asset-Backed Securities:                                          |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 3,936      |       |           | 6          |           |       |          | —     |   |   | 3,942 |   |
| Greater than 1 year and less than 3 years                         |       | 2,166      |       |           | —     |           |       |          | (4         | ) |   | 2,162 |   |
| Government/Agency  Securities:                                    |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 53,006     |       |           | 30         |           |       |          | —     |   |   | 53,036 |   |
| Greater than 1 year and less than 3 years                         |       | 2,000      |       |           | 4          |           |       |          | —     |   |   | 2,004 |   |
| Corporate Debt  Securities:                                       |       |       |       |           |       |           |       |          |       |   |   |   |   |
| One year or less                                                  |       | 40,824     |       |           | 102        |           |       |          | (5         | ) |   | 40,921 |   |
| Greater than 1 year and less than 3 years                         |       | 59,671     |       |           | 33         |           |       |          | (86        | ) |   | 59,618 |   |
| Total Securities  held to maturity                                |       | 164,638    |       |           | 192        |           |       |          | (95        | ) |   | 164,735 |   |
| Available-for-sale  investments*                                  |       | 30,116     |       |           | 694        |           |       |          | —     |   |   | 30,810 |   |
| Total short- and  long-term investments at December 31, 2003 |       | $          | 194,754    |           |       | $              | 886        |          |       |   | $ | (95 | ) |   | $ | 195,545 |   |
|                                                                   |            |            |            |                |            |                |            |               |            |  |  |  |  |  |  |  |  |

----

*                    For the yearended December 31, 2003, the fair value of our available-for-saleinvestments increased by $694,000 and an unrealized gain is included as acomponent of stockholders’ equity.

**4. REVENUES**

*Development Agreements andLicensing Fees*.   Development agreement revenue includesreimbursement from Genentech and Novartis of selected current year clinicaltrial costs incurred for TNX-901. Development agreement revenue for 2004 alsoincludes $6.6 million received under the terms of the Tripartite CollaborationAgreement among Novartis, Genentech and Tanox dated February 25, 2004,representing reimbursement by Genentech and Novartis of a portion of theTNX-901 development costs incurred by Tanox in previous years. Licensing feerevenue includes payments received in exchange for rights to license andsublicense Tanox’s technology or product rights.

*Royalties.  *Royaltyrevenue of $13.3 million and $1.9 million on the net sales of Xolair for theyears ended December 31, 2004 and 2003, were calculated based on net salesreported to Tanox by Genentech and Novartis. Royalty revenue reflects creditsfor prior milestone payments made to Tanox and a one-time credit of $2.0million in favor of Genentech when net annual sales of Xolair first exceeded$100.0 million during 2004. Royalty revenue is net of amounts which are payableby Tanox to its former attorneys (see Note 11. Commitments and Contingencies).

Inthe United States, Tanox receives royalties on sales of Xolair and othercollaboration products and will receive a share of Novartis’ profits on thesesales. The Company also receives royalties on sales of Xolair and othercollaboration products outside the U.S. Tanox shares equally with Novartis thenet profits and net losses from sales of Xolair and other collaborationproducts in East Asia. Novartis profit-sharing and rest-of-world royaltypayments will be net of certain other credits, which, at December 31,2004, approximated $2.0 million. In addition, as a result of an adversearbitration award, 10% of all royalties received by Tanox on sales of Xolairand certain other anti-IgE products will be payable to its former 

51

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

attorneys, up to a maximum of $300 million. The Companyexpects that the net amount it will receive from Xolair sales, taking intoaccount both the foregoing credit and the amount payable to its formerattorneys will be in the range of 8% to 12% of the net sales depending on thesales level achieved and geographic distribution of the sales. Milestone andother credits caused the net amount that Tanox received from Xolair royaltiesto be below 8% of net sales in 2004.

**5. COLLABORATIONAND LICENSE AGREEMENTS**

*GenentechInc. and Novartis Pharma, AG.  *In 1990, Tanox entered into a Development and Licensing Agreement withCiba Geigy, AG (now Novartis Pharma AG) to jointly develop anti-IgE antibodiesto treat allergic diseases. In connection with the settlement of a lawsuit in 1996,Genentech joined the collaboration for the purpose of developing certainanti-IgE antibodies. Under the collaboration agreements we may receive up to anadditional $25.0 million in Xolair-related milestone payments of which $7.2million would be payable to the former attorneys and $2.5 million would becreditable against future royalty payments.

In the United States, Tanoxreceives royalties on sales of Xolair and other collaboration products and willreceive a share of Novartis’ net profits on these sales. Tanox also receivesroyalties from Novartis on sales of Xolair in Europe and the rest of the world.Tanox shares equally with Novartis the net profits and the net losses from thedevelopment and commercialization of Xolair and other collaboration products inChina, Hong Kong, Korea, Singapore and Taiwan. The royalty and profit-sharingpayments to Tanox are reduced by certain milestone and other credits. Inaddition, 10% of all royalties received by Tanox from sales of Xolair andcertain other collaboration products will be payable to Tanox’s formerattorneys, up to a maximum of $300.0 million, as a result of the arbitrationaward (see Note 4. Revenues).

Novartis and Genentech areresponsible for manufacturing Xolair and other selected anti-IgE productsworldwide. In consideration for relinquishing any rights to manufacture up to50% of the worldwide requirements of those products, Tanox will receivequarterly payments from Novartis or Genentech based on the quantity of productmanufactured and vialed.

*BiogenIDEC, Inc.  *In1998, Tanox entered into an agreement to license from Biogen, Inc. (nowBiogen IDEC, Inc.) its anti-CD4 monoclonal antibody and intellectualproperty on an exclusive worldwide basis. Biogen IDEC owns issued U.S., European,Canadian and Australian patents and has pending applications in Japan, whichcover our TNX-355 product. The Company paid Biogen IDEC a license fee andagreed to make additional development milestone payments and royalty paymentsto Biogen IDEC based on annual net sales revenue levels. If certain milestonesare met, the Company may make up to an aggregate of $1.4 million (or $10.4million in the event Tanox merges or affiliates with a company similar in sizeto Biogen) in product license fees and development milestone payments underthis agreement, of which the Company has paid $200,000. The license terminateson a country-by-country basis on the later of the expiration of 12 yearsfollowing the first commercial product sale or the expiration or invalidity ofapplicable patents.

*ProteinDesign Labs, Inc.  *In 2000, Tanox entered into an agreement with Protein Design Labs, Inc.(PDL) to acquire the right to non-exclusive licenses to patents and patentapplications owned by PDL for up to four of the Company’s antibodies. Under theagreement, the Company paid initial license fees to PDL of $2.5 million, inaddition to $1.5 million that was paid to PDL in 1998 under a prior licensingagreement, and must exercise the option for license not later than March 17,2005. If the Company exercises its options to license PDL’s patents for allfour antibodies, the Company agreed to pay PDL up to 

52

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

$4.0million ($1.0 million per antibody), plus maintenance fees. In addition, theCompany agreed to pay royalties on future sales if a product using the PDLtechnology is successfully commercialized. The Company has not exercised itsoption for any of the Company’s antibodies.

*Wyeth.  *In November 2003, the Company entered into cross licensing agreements with WyethPharmaceuticals, a division of Wyeth, with respect to patent rights covering anew class of drugs for the treatment of osteoporosis and/or other non-oncologicbone-related diseases or disorders. Under the agreements, Wyeth received alicense under Tanox patents to develop a small molecule-based drug, and Tanoxreceived a license under Wyeth’s patent applications to develop anantibody-based drug. The research is based on a Tanox patented proprietarytarget gene. Tanox may receive milestone and royalty payments fromWyeth-developed products and may pay Wyeth milestones and royalties fromTanox-developed products. Tanox received an upfront license payment of $1.0million from Wyeth in 2003.

*Dyax Corp.  *InNovember 2004, the Company entered into an agreement with Dyax Corp.(Dyax) to obtain a non-exclusive license to its proprietary antibody phagedisplay libraries. Tanox intends to utilize the Dyax libraries to identifyfully human monoclonal antibodies that bind with high specificity and affinityto a number of its targets. Under the terms of the agreement, Tanox paid Dyaxan up front license fee of $900,000. Dyax is also entitled to annual technologylicense fees, clinical milestone payments, and royalties upon successfulcommercialization by Tanox of products based on antibodies identified from theDyax libraries.

**6. ACCRUED LIABILITIES**

Accruedliabilities at December 31, 2004 and 2003, consist of the following (inthousands):
| ** **                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Payroll                                 |       | $        | 1,230      |     | $          | 761 |   |
| Vacation                                |       | 410      |       | 290      |       |
| Taxes                                   |       | 695      |       | 709      |       |
| Legal and  professional fees            |       | 470      |       | 394      |       |
| Interest                                |       | —   |       | 693      |       |
| Clinical trial  costs                   |       | 469      |       | 384      |       |
| Contract  cancellation fee and expenses |       | 615      |       | —   |       |
| Commitment for  production materials    |       | 1,935    |       | —   |       |
| Other                                   |       | 268      |       | 159      |       |
|                                    |       | $        | 6,092      |     | $          | 3,390 |   |

 

**7. NOTES PAYABLE**

*Note Payable to Bank*.   Tanoxborrowed $5.0 million in September 2002 from a bank under a $16.0 millionRevolving Line of Credit Note Agreement (LOC Agreement). Under the term of theLOC Agreement, Tanox may secure advances up to the aggregate principal amountof $16.0 million, the proceeds of which can be used to finance the purchase ofproperty, plant and equipment. The outstanding balance is payable in full on September 27,2006, and advances bear interest at the lesser of the Prime Rate or LIBOR plus1%, which at December 31, 2004 and 2003 was 3.50% and 2.25%, respectively.The Note is collateralized with cash and investments equal to or greater than100% of the outstanding principal balance of the Note.

53

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

*Note Payable to Related Party*.   From1994 through 1998, Novartis advanced Tanox $10.0 million, pursuant to a loanagreement, to finance the construction of our pilot plant manufacturingfacility. Under the terms of the Amended and Restated Development and LicensingAgreement entered into between Tanox and Novartis Pharma A.G. in February 2004,the principal and accrued interest of $10,742,000 on this loan were forgiven infull by Novartis and recorded by Tanox as a capital infusion since Novartis isa related party for accounting purposes.

**8. INCOME TAXES**

Tanox’spretax income (loss) consists of the following (in thousands):
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| U.S.       |       | $        | (2,821     | )        | $          | 119      |       | $ | (20,084 | ) |
| Foreign    |       | (7,469   | )          | (4,985   | )          | (5,938   | )          |
|       |       | $        | (10,290    | )        | $          | (4,866   | )          | $ | (26,022 | ) |

 

Thecomponents of the provision/(benefit) for income taxes are as follows (inthousands):
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Current    |       | $        | —     |     | $          | (228     | )          | $ | — |   |
| Deferred   |       | —   |       | —   |       | —   |       |
|       |       | $        | —     |     | $          | (228     | )          | $ | — |   |

 

For 2004, 2003 and 2002 the effective income taxprovision varied from that computed at the statutory federal income tax rate of35% primarily due to an increase in the valuation allowance and nondeductibleforeign losses. Foreign pretax losses relate to Tanox wholly ownedsubsidiaries.

Significant components ofTanox’s deferred tax assets at December 31 are as follows (in thousands):
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Federal NOL  carryforwards                      |       | $        | 29,723     |     | $          | 28,191 |   |
| In-process  research and development            |       | —   |       | 1,335    |       |
| Foreign NOL  carryforwards                      |       | 8,849    |       | 6,235    |       |
| Deferred  compensation related to stock options |       | —   |       | 2,225    |       |
| Research and  development tax credit            |       | 4,009    |       | 3,561    |       |
| Alternative  minimum tax credit                 |       | 20       |       | 20       |       |
| Accruals not  currently deductible              |       | 1,239    |       | 323      |       |
| Capitalized  research                           |       | 875      |       | 875      |       |
| Other, net                                      |       | 210      |       | 179      |       |
| Total deferred tax assets                       |       | 44,925   |       | 42,944   |       |
| Differences in  book and tax depreciation       |       | (641     | )          | (634     | )          |
| Deferred tax  valuation allowance               |       | (44,284  | )          | (42,310  | )          |
| Net deferred  taxes                             |       | $        | —     |     | $          | — |   |

 

54

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**Tanox, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements—(Continued)**

 

At December 31, 2004and 2003, Tanox had federal regular tax NOL carryforwards and alternativeminimum tax NOL carryforwards of approximately $84.9 million and $81.2 million,respectively, which will begin to expire in 2019. Tanox also had a foreign NOLcarryforward of approximately $25.3 million which will be available to offsetthe separate company taxable income of certain foreign subsidiaries. Additionally,Tanox has an unused U.S. research and development tax credit carryforward at December 31,2004, of approximately $4.0 million, which began to expire in 2002. Tanox alsohas alternative minimum tax credit carryforwards of approximately $20,000 as ofDecember 31, 2004. As Tanox has incurred cumulative losses to date andthere is no assurance of future taxable income, a valuation allowance has beenestablished to fully offset the net deferred tax asset at December 31,2004 and 2003. Tanox’s valuation allowance increased to $44.4 million at December 31,2004, an increase of $2.0 million, primarily due to Tanox’s increase in NOLcarryforwards. Approximately $14.9 million of the valuation allowance relatesto tax benefits for stock option deductions included in the net operating losscarryforward, which when realized will be allocated directly to contributed capitalto the extent the benefits exceed amounts attributable to deferred compensationexpense.

**9. LEASE OBLIGATIONS**

Tanox leases equipment under non-cancelable operatingleases. These leases expire at various dates through 2008. Future minimum leaseobligations under non-cancelable leases at December 31, 2004, are asfollows (in thousands):

Year ending December 31- 

| 2005                 |   | $      | 79     |   |
|----------------------|--------|--------|--------|--------|
| 2006                 |   | 30     |   |
| 2007                 |   | 7      |   |
| 2008                 |   | 1      |   |
| 2009 and  thereafter |   | — |   |
| Total                |   | $      | 117    |   |

 

Tanox incurred rentexpense of $171,000, $439,000 and $598,000 in 2004, 2003 and 2002, respectively.In 2002, Tanox purchased the 43,560 square feet research and pilotmanufacturing facility it had previously leased in Houston, Texas and acquired a 68,000 square feet office andwarehouse building adjacent to its existing facility, which now serves as aresearch lab and administrative office building. Tanox’s corporateadministrative offices previously occupied approximately 13,100 squarefeet in Houston, Texas under a lease that expired on March 31, 2004.

**10. CAPITAL STOCK**

***Preferred Stock***

Tanox is authorized toissue up to 10,000,000 shares of $.01 par value preferred stock. The board ofdirectors has the authority to issue these shares in one or more series and toestablish the rights, preferences and dividends for the shares. No shares ofpreferred stock have been issued.

***Stockholder Rights Agreement***

On July 27, 2001, the boardof directors of Tanox declared a dividend of one right for each outstandingshare of the common stock of recordat the close of business on August 10, 2001. Each right entitles theregistered holder to purchase a unit consisting of one one-hundredth of a share(a Fractional 

55

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**Tanox, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements—(Continued)**

 

Share)of Series A Junior Participating Preferred Stock, par value $0.01 pershare, at a purchase price of $140 per Fractional Share, subject to adjustment.The rights generally become exercisable if an acquiring partyaccumulates 20% or more of the common stock and, in such event, the holders ofthe rights (other than the acquiring person) would be entitled to purchaseeither Tanox’s stock or shares in an acquiring entity at half of market value. Tanoxis generally entitled to redeem the rights at $0.01 per right at any time untilthe tenth day following the time the rights become exercisable. The rights willexpire on August 10, 2011.

***Treasury Stock***

In September 2001,the board of directors of Tanox authorized the repurchase, at management’sdiscretion, of up to $4.0 million of Tanox common stock. In June 2002, theboard authorized the purchase of an additional $3.0 million pursuant to thestock repurchase program. As of December 31, 2004, the Company haspurchased a total of 554,700 shares at an aggregate cost of $6.3 million. Theaverage repurchased share price was $11.29.

***Stock Options***

In 1987, Tanox established the1987 Stock Option Plan (the 1987 Plan) covering key employees, officers anddirectors of Tanox. Under the terms of the 1987 Plan, as amended, the number ofshares of common stock eligible for issuance was 4,320,000. Options issuedunder the 1987 Plan were generally granted at a purchase price equal to thefair market value at the date of grant and are generally exercisable beginningtwo years after the date of grant for 40% of the shares, with the balance tobecome exercisable cumulatively in three installments of 20% each yearthereafter. Options expire ten years after the date of grant. At December 31,2004, options to purchase 302,660 shares of common stock were outstanding underthe 1987 Plan. The 1987 Plan expired June 24, 1997, and no more shares maybe granted under this plan.

Tanox established the 1997 StockPlan (the 1997 Plan) in November 1997. Under the terms of the 1997 Plan,Tanox may grant options to purchase up to 8,000,000 shares of common stock toemployees, directors, advisors and consultants. The 1997 Plan also provides forseveral types of grants including incentive stock options, non-qualified stockoptions, stock appreciation rights, stock awards, stock purchases andperformance units. Incentive stock options provide the right to purchase commonstock at a price not less than 100% of the fair value of common stock on thedate of the grant. Non-qualified stock options provide the right to purchasecommon stock at a price not less than 50% of the fair value of the common stockon the date of the grant. The options granted under the 1997 Plan generallyexpire ten years after date of grant and are generally completely exercisablefive years after the grant date. At December 31, 2004, options to purchase1,927,546 shares of common stock were outstanding under the 1997 Plan, and5,651,526 shares were available for future grants. The 1997 Plan will expire onOctober 31, 2007.

In January 1992, Tanoxestablished the 1992 Non-Employee Directors Stock Options Plan (the 1992Directors Plan) and reserved 480,000 shares of common stock for issuance uponthe exercise of options granted pursuant to the 1992 Directors Plan. Unlessotherwise provided, options granted under the 1992 Directors Plan vestedone-third annually from the date of grant. The exercise price of the optionsgranted was determined by a committee appointed by Tanox’s board of directors. AtDecember 31, 2004, options to purchase 30,000 shares of common stock wereoutstanding under the 1992 Directors Plan. The 1992 Directors Plan expired on January 10,2002, and no more shares may be granted under this plan.

In February 2000, Tanoxestablished the 2000 Non-Employee Directors’ Stock Option Plan (the 2000Directors Plan) and reserved 500,000 shares of common stock for issuance underthe plan. Under the 

56

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**Tanox, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements—(Continued)**

 

originalPlan, non-employee directors joining the board after April 6, 2000,automatically received a stock option to purchase 15,000 shares uponinitial election or appointment. Each such director also received a stockoption to purchase an additional 5,000 shares upon their re-election to theboard. The 2000 Directors Plan was amended in May 2001. To provide thatnon-employee directors joining the board after May 31, 2001, automaticallyreceive an option to purchase an equivalent number of shares of common stockhaving a Black-Scholes model value of $200,000. Non-employee directors wouldalso receive, immediately following any annual meeting of stockholders at whichdirectors are elected (beginning with the 2002 annual meeting), an option topurchase an equivalent number of shares of common stock having a Black-Scholesmodel value of $80,000, provided that the director did not receive an initialgrant under the plan within the prior six months. The 2000 Directors Plan wasagain amended in February 2004. Under the February 2004 amendment,the plan provides that non-employee directors receive, upon initial election tothe Board, an option to acquire 20,000 shares of common stock. Following eachannual meeting of stockholders at which directors are elected (beginning withthe 2004 annual meeting), the non-employee directors continuing in office wouldreceive options to acquire 10,000 shares of common stock. New directors whoreceived their initial option grant within six months prior to the first annualmeeting after their appointment would not be eligible for an option followingsuch meeting. All grants under the 2000 Directors Plan have a term of tenyears, are issued at fair market value and vest 1/36 per month from the date ofgrant over three years. At December 31, 2004, options to purchase 128,200shares of common stock were outstanding under the 2000 Directors Plan, and371,800 shares were available for future grants.

The following table summarizes stock option transactionssince December 31, 2001:

| ** **                          | ** ** | **Number of** | ** ** | ** **              | ** **   | **Weighted Average** | ** ** |
|-------------------------------------|------------|--------------------|------------|-------------------------|--------------|---------------------------|------------|
| ** **                          | ** ** | **Shares**         | ** ** | **Exercise Price** | ** **   | **Exercise Price**   | ** ** |
| Outstanding, December 31, 2001 |       | 2,012,596          |       | 0.83  - 48.00           |         |                      | 21.88      |   |   |
| Granted                             |       | 751,675            |       | 9.54  - 18.50           |         |                      | 13.34      |   |   |
| Exercised                           |       | (145,040           | )          | 0.83  - 12.50           |         |                      | 2.38       |   |   |
| Canceled                            |       | (541,472           | )          | 11.53  - 31.55          |         |                      | 28.52      |   |   |
| Outstanding, December 31, 2002 |       | 2,077,759          |       | 1.04  - 48.00           |         |                      | 18.42      |   |   |
| Granted                             |       | 456,100            |       | 8.06  - 20.36           |         |                      | 9.28       |   |   |
| Exercised                           |       | (168,805           | )          | 1.04  - 17.52           |         |                      | 7.15       |   |   |
| Canceled                            |       | (315,542           | )          | 8.06  - 47.31           |         |                      | 18.96      |   |   |
| Outstanding, December 31, 2003 |       | 2,049,512          |       | 1.04  - 48.00           |         |                      | 17.24      |   |   |
| Granted                             |       | 687,465            |       | 13.31  - 18.34          |         |                      | 15.94      |   |   |
| Exercised                           |       | (61,552            | )          | 1.04  - 17.52           |         |                      | 9.00       |   |   |
| Canceled                            |       | (287,019           | )          | 8.06  - 47.31           |         |                      | 24.42      |   |   |
| Outstanding, December 31, 2004 |       | 2,388,406          |       | 4.06  - 48.00           |         |                      | 16.21      |   |   |
| Exercisable, December 31, 2004 |       | 1,018,697          |       | $                       | 4.06 - 48.00 |                      |       | $ | 17.33 |   |   |
|                                     |            |                    |            |                         |              |                           |            |  |  |  |  |

 

57

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**Tanox, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements—(Continued)**

 

The following table summarizes information aboutfixed-price stock options outstanding at December 31, 2004:
| ** **                                     | ** ** | **Options Outstanding at** | ** ** | **Options Exercisable at** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **December 31, 2004** | ** ** | **December 31, 2004** | ** ** |
| ** **                                     | ** ** | ** **                 | ** ** | **Weighted**               | ** ** | ** ** | ** ** | **No. of** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **No. of**            | ** ** | **Average**                | ** ** | **Weighted** | ** ** | **Shares** | ** ** | **Weighted** | ** ** |
| ** **                                     | ** ** | **Shares**                 | ** ** | **Remaining**              | ** ** | **Average** | ** ** | **Subject to** | ** ** | **Average** | ** ** |
| ** **                                     | ** ** | **Subject to**             | ** ** | **Contractual**            | ** ** | **Exercise** | ** ** | **Exercisable** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices**                   | ** ** | **Options**                | ** ** | **Life (in Yrs)**          | ** ** | **Price** | ** ** | **Options** | ** ** | **Price** | ** ** |
| $    1.04 **-  **4.80 |       | 8,000                      |       | 4.1                        |       | $ | 4.06 |   | 8,000 |   | $ | 4.06 |   |
| $    4.81 **-  **9.60 |       | 651,370                    |       | 5.3                        |       | 7.87 |   | 387,290 |   | 7.65 |   |
| $    9.61 **-** 14.40      |       | 636,701                    |       | 7.4                        |       | 13.52 |   | 239,276 |   | 13.23 |   |
| $ 14.41 **-**19.20                        |       | 761,757                    |       | 8.6                        |       | 16.45 |   | 140,420 |   | 16.79 |   |
| $ 19.21 **-** 24.00                       |       | 24,378                     |       | 1.3                        |       | 19.32 |   | 18,391 |   | 19.32 |   |
| $ 24.01 **-** 28.80                       |       | 19,200                     |       | 6.4                        |       | 27.79 |   | 18,720 |   | 27.86 |   |
| $ 28.81 **-** 38.40                       |       | 200,000                    |       | 6.0                        |       | 36.73 |   | 138,000 |   | 36.80 |   |
| $ 38.41 **-** 43.20                       |       | 15,000                     |       | 5.7                        |       | 40.38 |   | 15,000 |   | 40.38 |   |
| $ 43.21 **-** 48.00                       |       | 72,000                     |       | 5.6                        |       | 47.96 |   | 53,600 |   | 47.96 |   |
|                                           |       | 2,388,406                  |       | 6.9                        |       | 16.21 |   | 1,018,697 |   | 17.33 |   |
|                                                |            |                            |            |                            |            |  |  |  |  |  |  |  |  |

 

Tanox follows SFAS No. 123,which requires a fair value based method of accounting for employee stockoptions or allows an entity to continue to account for its employee stockoptions using the intrinsic value based method of accounting prescribed by APB No. 25. SFAS No. 123 requires Tanox todisclose the income statement effect of the alternative fair value methodassuming Tanox was required to record compensation expense for stock optionsequal to the assumed fair value on the grant date.

The proforma information regarding net loss required bySFAS No. 123 has been included in Note 2. The fair value of each optiongrant is estimated using the Black-Scholes option-pricing model. TheBlack-Scholes model uses grant prices, as stated in the option agreements,market price as established by stock sales and deemed market prices establishedby the Compensation Committee of Tanox’s board of directors prior to Tanox’sinitial public offering (IPO) and fair market value established by closingprices on the NASDAQ Stock Market following the IPO. The following assumptionswere used in the Black-Scholes option-pricing model:
| ** **                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected dividend yield   |       | —   |       | —   |       | —   |       |
| Expected price volatility |       | 69%      |       | 74%      |       | 80%      |       |
| Risk-free interest rate   |       | 3.46%    |       | 2.54%    |       | 2.21%    |       |
| Expected life of option   |       | 4 years  |       | 4 years  |       | 4 years  |       |
| Expected turnover         |       | 8%       |       | 10%      |       | 7%       |       |

 

58

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**Tanox, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements—(Continued)**

 

The number and weighted averagefair value of options granted in 2004, 2003 and 2002 is as follows:
| ** **                                           | ** ** | **2004**   | ** ** | **2003**       | ** ** | **2002**   | ** ** |
|------------------------------------------------------|------------|------------|------------|----------------|------------|------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | **Weighted**   | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | **Average**    | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                           | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
| Option exercise price equals fair market value       |       | 239,700    |       | $              | 15.82      |       | 432,100    |   | $ | 8.98 |   | 727,025 |   | $ | 13.26 |   |
| Option exercise price greater than fair market value |       | 447,765    |       | $              | 16.01      |       | 24,000     |   | $ | 14.63 |   | 7,500 |   | $ | 11.05 |   |
| Option  exercise price less than fair market value   |       | —     |       | $              | —     |       | —     |   | $ | — |   | 17,150 |   | $ | 17.41 |   |
|                                                      |            |            |            |                |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Reserved Shares***

The Company has reserved shares of common stock forfuture issuance of stock options under plans, all of which have been approvedby stockholders, as follows at December 31, 2004:

| Outstanding options        |   | 2,388,406 |   |
|----------------------------|--------|-----------|--------|
| Reserved for future grants |   | 6,023,326 |   |
|                       |   | 8,411,732 |   |

 

**11. COMMITMENTS AND CONTINGENCIES**

Tanoxhad been engaged in litigation in connection with a fee dispute with the lawfirms that represented the Company in litigation with Genentech relating to,among other things, the intellectual property rights surrounding thedevelopment of anti-IgE technology. An arbitration panel issued an awardentitling the attorneys to receive (1) approximately $3.5 million,including interest, (2) payments ranging from 331¤3% to 40% of the future milestone payments, inexcess of the first $1 million, Tanox would receive from Genentechfollowing product approval and (3) 10% of the royalties that Tanox wouldreceive on sales of certain anti-IgE products, including Xolair. The 10% ofroyalties received by Tanox is required to be paid to the attorneys within 30days of the end of the calendar quarter in which the royalty payments arereceived by Tanox. At December 31, 2004, Tanox had an accrued liability of$864,000 with respect to amounts that would be payable to the attorneys onroyalties or received or receivable by Tanox on net sales of Xolair.

Fromtime to time Tanox is a defendant in other lawsuits incidental to its business.Management believes that the outcome of these lawsuits will not be material toTanox’s financial statements.

***401(k) Plan***

EffectiveJanuary 1, 1992, Tanox adopted a qualified retirement plan (the 401(k) Plan)covering all of Tanox’s U.S. employees who are at least 21 years of age andhave completed at least 90 days of service with Tanox. Pursuant to the 401(k) Plan,employees may elect to reduce their current compensation by up to thestatutorily prescribed annual limit and have the amount of such reductioncontributed to the 401(k) Plan. The 401(k) Plan permits, but does notrequire, additional matching contributions by Tanox on behalf of allparticipants in the 401(k) Plan. Tanox’s matching contributions to the 401(k) Plantotaled approximately $389,000, $331,000 and $337,000 in 2004, 2003 and 2002,respectively.

59

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

**12. GEOGRAPHIC AREAS**

Tanoxoperates in a single business segment. Tanox’s operations by geographic areafor the years ended December 31, 2004, 2003 and 2002, are presented below(in thousands):
| ** **                               | ** ** | **Total  Revenues** | ** ** | **Net Loss** | ** ** | ** Identifiable   Assets** | ** ** |
|------------------------------------------|------------|---------------------|------------|-------------------|------------|--------------------------------------|------------|
| Year Ended  December 31, 2004— |       |                |       |              |       |                                 |       |   |   |
| Americas                                 |       | $                   | 20,435     |              | $          | (10,290                              | )          |   | $ | 238,553 |   |   |
| Europe                                   |       | 71                  |       | —            |       |                                 | —     |   |   |
| Asia                                     |       | —              |       | —            |       |                                 | —     |   |   |
| Interarea eliminations                   |       | —              |       | —            |       |                                 | —     |   |   |
|                                     |       | $                   | 20,506     |              | $          | (10,290                              | )          |   | $ | 238,553 |   |   |
| Year Ended  December 31, 2003— |       |                |       |              |       |                                 |       |   |   |
| Americas                                 |       | $                   | 18,481     |              | $          | (4,333                               | )          |   | $ | 251,856 |   |   |
| Europe                                   |       | 6                   |       | —            |       |                                 | —     |   |   |
| Asia                                     |       | —              |       | (305              | )          |                                 | —     |   |   |
| Interarea eliminations                   |       | —              |       | —            |       |                                 | —     |   |   |
|                                     |       | $                   | 18,487     |              | $          | (4,638                               | )          |   | $ | 251,856 |   |   |
| Year Ended  December 31, 2002— |       |                |       |              |       |                                 |       |   |   |
| Americas                                 |       | $                   | 560        |              | $          | (25,723                              | )          |   | $ | 262,134 |   |   |
| Europe                                   |       | —              |       | (23               | )          |                                 | 553        |   |   |
| Asia                                     |       | —              |       | (276              | )          |                                 | 672        |   |   |
| Interarea eliminations                   |       | —              |       | —            |       |                                 | (12,148    | ) |   |
|                                     |       | $                   | 560        |              | $          | (26,022                              | )          |   | $ | 251,211 |   |   |

 

Seenote 2 for disclosure of major customers that derive greater than 10% of totalrevenue.

**13. QUARTERLY FINANCIAL DATA (Unaudited) (in thousandsexcept per share data)**
| ** **                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------|------------|----------------------------------|------------|
| **2004**                      | ** ** | ** **                       | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Revenues                      |       |                             | $          | 8,994 |   |   | $ | 3,458 |   |   | $ | 2,466 |   |   |   | $ | 5,588 |   |   |
| Income (loss) from operations |       |                             | 1,770      |   |   | (4,904 | ) |   | (5,795 | ) |   |   | (4,798 | ) |   |
| Net income (loss)             |       |                             | 2,590      |   |   | (4,124 | ) |   | (4,913 | ) |   |   | (3,843 | ) |   |
| Net  income (loss) per share: |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                         |       |                             | 0.06       |   |   | (0.09 | ) |   | (0.11 | ) |   |   | (0.09 | ) |   |
| Diluted                       |       |                             | 0.06       |   |   | (0.09 | ) |   | (0.11 | ) |   |   | (0.09 | ) |   |
|                               |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------|------------|----------------------------------|------------|
| **2003**                      | ** ** | ** **                       | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Revenues                      |       | $                                | 5          |   | $ | 14,773 |   |   | $ | 899 |   |   |   | $ | 2,810 |   |   |
| Income (loss) from operations |       | (7,812                           | )          | 7,507 |   |   | (5,579 | ) |   |   | (4,003 | ) |   |
| Net income (loss)             |       | (6,349                           | )          | 8,921 |   |   | (4,361 | ) |   |   | (2,849 | ) |   |
| Net  income (loss) per share: |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Basic                         |       | (0.14                            | )          | 0.20 |   |   | (0.10 | ) |   |   | (0.07 | ) |   |
| Diluted                       |       | (0.14                            | )          | 0.20 |   |   | (0.10 | ) |   |   | (0.07 | ) |   |
|                               |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

60

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**Tanox, Inc. and Subsidiaries Notes to Consolidated Financial Statements—(Continued)**

**14. SUBSEQUENT EVENTS(Unaudited)**

***Lease assignment and asset purchase***

Pursuant to a LeaseAssignment and Asset Purchase Agreement dated December 9, 2004, betweenBiogen IDEC and Tanox, Inc., and effective on January 10, 2005, Tanoxacquired from Biogen IDEC certain assets such as manufacturing, processdevelopment and QA/QC equipment, related documentation and furniture andfixtures housed in a 76,000 square foot leased facility located in San Diego,California. Tanox also assumed the obligations of a triple net lease for thefacility, which extends until October 2011, with two five-year extensionoptions, which the Company considers an operating lease. Tanox paidapproximately $5.6 million for the assets. As partial consideration for Tanox’sagreement to the extension of the lease term to September 30, 2011 andassuming Tanox is not then in default under the lease agreement, Biogen IDECagreed to make two payments to Tanox, each in the amount of approximately $2.4million, on September 30, 2007 and November 30, 2008. The totalfuture lease payment obligation of Tanox for this lease assignment through2011, net of the two payments from Biogen IDEC, is $24.6 million.

***Letter Agreement***

Tanox entered into a manufacturing and supplyagreement in July 2004 to have a third party manufacture and supply Tanox’sTNX-355 for Phase 3 clinical trials and potential product launch. Paymentsdue to this third party under the agreement are based on the achievement ofmanufacturing deliverables and quantities to be manufactured based on the sizeof clinical trials. Under the terms of the agreement, if Tanox were toterminate the agreement before or upon completion of the technology transferdeliverable (Research Stage), it would be required to pay a cancellation feeequal to twenty-five percent of the un-invoiced portion of the remainingprocess development program balance, as defined in the agreement.

Tanox and the third party manufacturer begandiscussions in the fourth quarter of 2004 related to revisions to the agreementbecause Tanox determined that it would produce TNX-355 for Phase 3clinical trials in the San Diego manufacturing facility on which it assumed thelease in January 2005. In February 2005, a letter agreement with thethird party manufacturer was reached to suspend all provisions of the agreementfor a period to be determined by Tanox, but not to exceed 30 months. Tanoxplans to resume production of TNX-355 under this agreement on or before August 30,2007.

Under the terms of the letter agreement, Tanox willpay a total of $1.7 million of which $340,000 represents a cancellation fee andthe remaining $1,360,000 may be credited against future work performed by thethird party manufacturer, subject to certain limitations. Tanox will also pay$275,000 for work performed by the third party manufacturer as of December 31,2004. The total amount accrued as of December 31, 2004 related to thistransaction was $615,000 as research and development expense.

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**ITEM 9. Changes in and Disagreements with Accountants onAccounting and Financial Disclosure**

None.

**ITEM 9A. Controls and Procedures**

*Conclusion Regarding theEffectiveness of Disclosure Controls and Procedures.  *Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rules 13a-15(e) and 15d-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended (the Exchange Act). Basedon this evaluation, our principal executive officer and our principal financialofficer concluded that our disclosure controls and procedures were effective asof the end of the period covered by this annual report.

*Management’s Report on InternalControl Over Financial Reporting.  *Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and15d-15(f). Under the supervision and with the participation of ourmanagement, including our principal executive officer and principal financialofficer, we conducted an evaluation of the effectiveness of our internalcontrol over financial reporting based on the framework in *Internal Control—IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission. Based on our evaluation under the framework in *Internal Control—IntegratedFramework*, our management concluded that our internal control overfinancial reporting was effective as of December 31, 2004.

Our management’s assessment of the effectiveness ofour internal control over financial reporting as of December 31, 2004 hasbeen audited by Ernst & Young LLP, an independent registered publicaccounting firm that audited our financial statements included in this annualreport, as stated in their report which is included elsewhere herein.

*Changesin Internal Control Over Financial Reporting*.   There have been no changes inthe Company’s internal control over financial reporting that occurred duringthe fourth quarter of fiscal 2004 that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

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**PART III**

**ITEM10. Directors and Executive Officers of the Registrant**

The information regardingdirectors that is required by this item is incorporated by reference from thediscussion in the Proxy Statement captioned “Proposal 1*—*Electionof Directors” and “Beneficial Ownership Table”. Information concerning ourexecutive officers is set forth under Part I of this Form 10-K.

**ITEM 11. Executive Compensation**

The information that isrequired by this item is incorporated by reference from the discussion in theProxy Statement captioned “Executive Compensation”.

**ITEM12. Security Ownership of Certain Beneficial Owners and Management**

The information that is requiredby this item is incorporated by reference from the discussion in the ProxyStatement captioned “Beneficial Ownership Table”.

**ITEM13. Certain Relationships and Related Transactions**

The information that isrequired by this item is incorporated by reference from the discussion in theProxy Statement captioned “Other Transactions”.

**ITEM14. Principal Accounting Fees and Services**

The information that is required by this item isincorporated by reference from the discussion in the Proxy Statement captioned “PrincipalAccounting Fees and Services”.

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**PART IV**

**ITEM15. Exhibits, Financial Statement Schedules and Reports on Form 8-K**
| (a) 1. |   | Index to Financial Statements                                                                                            |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------|
|   |   | Report of Independent  Auditors                                                                                          |
|   |   | Consolidated Balance  Sheets as of December 31, 2004 and 2003                                                       |
|   |   | Consolidated  Statements of Operations and Comprehensive Loss for the years ended  December 31, 2004, 2003 and 2002 |
|   |   | Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2004, 2003 and 2002         |
|   |   | Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                        |
|   |   | Notes to Consolidated  Financial Statements                                                                              |
| 2.     |   | Financial Statement  Schedules.                                                                                          |

 

All schedules are omitted because they are notapplicable or not required, or because the required information is included inthe consolidated financial statements or notes thereto.
| 3. |   | Exhibits. |
|----|--------|-----------|

 
| 3(i).1  |   | Amended and Restated  Certificate of Incorporation of the Registrant, as amended.(1)                                                                                                                                                               |
|---------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3(i).2  |   | Certificate of  Designations of Series A Junior Participating Preferred Stock(5)                                                                                                                                                              |
| 3(ii).1 |   | Bylaws of the Registrant,  as currently in effect.(7)                                                                                                                                                                                              |
| 4.1     |   | Specimen of Common Stock  Certificate, $.01 par value, of the Registrant.(1)                                                                                                                                                                       |
| 10.1    |   | Form of  Indemnification Agreement between the Registrant and its officers and  directors.(1)(9)                                                                                                                                              |
| 10.2    |   | 1987 Stock Option Plan  of the Registrant, as amended.(1)(9)                                                                                                                                                                                       |
| 10.3    |   | 1992 Non-employee  Directors Stock Option Plan of the Registrant.(1)(9)                                                                                                                                                                            |
| 10.4    |   | 1997 Stock Plan of the  Registrant.(1)(9)                                                                                                                                                                                                          |
| 10.5    |   | First Amendment to the  Tanox, Inc. 1997 Stock Plan.(2)(9)                                                                                                                                                                                    |
| 10.6    |   | 2000 Non-Employee  Directors’ Stock Option Plan.(1)(9)                                                                                                                                                                                        |
| 10.7    |   | First Amendment to the  2000 Non-Employee Directors’ Stock Option Plan(3)(9)                                                                                                                                                                  |
| 10.8    |   | Second Amendment to the  2000 Non-Employee Directors’ Stock Option Plan(9)                                                                                                                                                                    |
| 10.9    |   | Form of Stock  Option Agreement (Officer Versions).(9)                                                                                                                                                                                        |
| 10.10   |   | Form of Stock  Option Agreement (Director Versions).(9)                                                                                                                                                                                       |
| 10.11   |   | Stock  Purchase Agreement, dated July 14, 1987, by and among the Registrant   and  Tse Wen Chang, Nancy T. Chang, Alafi Capital Company, Shireen Alafi, Joseph  Heskel, Trustee for Christopher Alafi, and Invitron Corporation.(1) |
| 10.12   |   | License for Winter  Patent, dated June 26, 1989, by and between Medical Research Council and  the Registrant.(1)                                                                                                                              |
| 10.13   |   | Amendment to the License  for Winter Patent, dated February 9, 1990, by and between Medical Research  Council and the Registrant.(1)                                                                                                          |

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| 10.14 |   | Outline of Terms for Settlement of the Litigations  Among Genentech, Inc., Genentech International, Ltd., the Registrant and  Ciba-Geigy Limited Relating to Anti-IgE Inhibiting Monoclonal Antibodies,  dated July 8, 1996.(1)                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.15 |   | Settlement and  Cross-Licensing Agreement, dated July 8, 1996, by and between the  Registrant and Genentech, Inc. and Genentech International Limited.(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.16 |   | Amendment No. 1 to  the Settlement and Cross-Licensing Agreement dated as of February 25,  2004, by and between Genentech, Inc. and the Registrant.(8)(10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.17 |   | Settlement and  Participation Agreement, dated July 8, 1996, by and between the  Registrant and F. Hoffman-La Roche, Ltd., Hoffman-La Roche, Inc., Roche  Holding Ltd. and Roche Holdings, Inc.(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.18 |   | Master Agreement, dated  March 17, 2000, by and between the Registrant and Protein Design  Labs, Inc.(1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.19 |   | Rights Agreement dated  as of July 27, 2001 between the Registrant and American Stock  Transfer & Trust Company, as Rights Agent, which includes as  Exhibit A the form of Rights Certificate and as Exhibit B the  Summary of Rights to Purchase Common Stock.(4)                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.20 |   | Credit Agreement dated  September 27, 2002, by and between Wells Fargo Bank Texas, National  Association and the Registrant.(6)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.21 |   | Tripartite Collaboration  Agreement dated as of February 25, 2004, by and between Novartis Pharma  AG, Genentech, Inc. and the Registrant.(8)(10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.22 |   | Amended and Restated  Development and Licensing Agreement dated as of February 25, 2004, by  and between the Registrant and Novartis Pharma AG.(8)(10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.23 |   | Ancillary Development  and Licensing Agreement dated as of February 25, 2004, by and between  the Registrant and Novartis Pharma AG.(8)(10)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.24 |   | Lease Assignment and  Asset Purchase Agreement dated December 9, 2004, by and between the  Registrant and Biogen IDEC, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.25 |   | Fourth Lease Amendment  and Assignment Agreement dated December 9, 2004 by and between TSI,  L.P., Biogen IDEC, Inc. and the Registrant, including the Lease  Agreement dated July 9, 1992 by and between Torrey Sorrento, Inc.  (TSI and n/k/a TSI, L.P.) and IDEC Pharmaceuticals Corporation (IDEC and  n/k/a Biogen IDEC, Inc.), First Amendment to Lease Agreement dated  November 9, 1992 by and between TSI and IDEC, Second Amendment to Lease  Agreement dated December 30, 1994 by and between TSI and IDEC, and Third  Lease Amendment Agreement dated April 22, 2004 by and between TSI, L.P.  and Biogen IDEC, Inc. |
| 21.1  |   | List of Subsidiaries of  the Registrant.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 23.1  |   | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 31.1  |   | Certification of CEO  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2  |   | Certification of Vice  President of Finance Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 32    |   | Certification of CEO and  Vice President of Finance Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

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        (1)        Filedas an exhibit to our Registration Statement on Form S-1 (no. 333-90625)and incorporated herein by reference.

        (2)        Filedas an exhibit to our Quarterly Report on Form 10-Q for the quarterended September 30, 2000, and incorporated herein by reference.

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        (3)        Filedas an exhibit to our Quarterly Report on Form 10-Q for the quarterended June 30, 2001, and incorporated herein by reference.

        (4)        Filedas an exhibit to our Current Report on Form 8-K dated August 2,2001.

        (5)        Filedas an exhibit to our Quarterly Report on Form 10-Q for the quarterended June 30, 2002, and incorporated herein by reference.

        (6)        Filedas an exhibit to our Quarterly Report on Form 10-Q for the quarterended September 30, 2002, and incorporated herein by reference.

        (7)        Filedas an exhibit to our Current Report on Form 8-K dated November 20,2003.

        (8)        Filedas an exhibit to our Quarterly Report on Form 10-Q for the quarterended March 31, 2004, and incorporated herein by reference.

        (9)        Managementcontract or compensatory plan.

 (10)        Certaininformation in this exhibit is subject to a request for confidential treatment.In accordance with Rule 24b-2 under the Exchange Act, thisinformation has been redacted and provided separately to the Securities andExchange Commission.
| (b)    |   | Reports on Form 8-K                                                                                                                                                                                                                                                   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | Current Report on  Form 8-K dated October 12, 2004, filed pursuant to Item 7.01  of the report and reporting sales of Xolair for the third quarter ended  September 30, 2004, as reported by Genentech.                                                     |
|   |   | Current Report on  Form 8-K dated October 15, 2004, filed pursuant to Item 7.01  of the report and reporting contract negotiations with Biogen IDEC to acquire  manufacturing assets and assume the lease on a manufacturing facility in San  Diego, California. |
|   |   | Current Report on  Form 8-K dated December 15, 2004, filed pursuant to Item 1.01  of the report and reporting the entry into a Lease Assignment and Asset  Purchase Agreement with Biogen IDEC.                                                                  |

 

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|           | **TANOX, INC.**                                       |
|-----------|-------------------------------------------------------|
| By:  | /s/  Nancy T. Chang                                   |
|      | Nancy T. Chang  President and Chief Executive Officer |

 

Pursuant to therequirements of the Securities Exchange Act, this report has been signed by thefollowing persons on behalf of the registrant in the capacities and on the datesindicated:
|                         | **Signature** | ** **                                                               | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|---------------|--------------------------------------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/  Nancy T. Chang     |          | President, Chief  Executive Officer                                      |       | March 9, 2005 |
| Nancy T. Chang          |          |
| /s/  Gregory P. Guidroz |          | Vice President of  Finance  (Principal Financial and Accounting Officer) |       | March 9, 2005 |
| Gregory P.  Guidroz     |          |
| /s/  Osama Mikhail      |          | Chairman of the Board                                                    |       | March 9, 2005 |
| Osama Mikhail           |          |
| /s/  Tse Wen Chang      |          | Director                                                                 |       | March 9, 2005 |
| Tse Wen Chang           |          |
| /s/  William J. Jenkins |          | Director                                                                 |       | March 9, 2005 |
| William J.  Jenkins     |          |
| /s/  Heinz W. Bull      |          | Director                                                                 |       | March 9, 2005 |
| Heinz W. Bull           |          |
| /s/  Peter G. Traber    |          | Director                                                                 |       | March 9, 2005 |
| Peter G. Traber         |          |

 

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