Risks and Opportunities Report

MorphoSys is part of an industry that is characterized by constant change and progress. The challenges and opportunities in the healthcare industry are influenced by many different factors. Global demographic changes, medical advances and the desire for a better quality of life in emerging nations form a solid growth perspective for the pharmaceutical and biotechnology industry. Growing regulatory requirements in the area of drug development and the cost pressures on healthcare systems in particular must, however, also be considered.

MorphoSys seeks to recognize and utilize new opportunities for business success in order to increase the value of the Company in the long term. Corporate success cannot, however, be achieved without conscious risk-taking. As a result of its global activities, MorphoSys is exposed to a variety of risks which could affect the Companyʼs business performance. MorphoSysʼs risk management system helps to evaluate the risks associated with the Companyʼs strategic objectives. Regular strategy reviews ensure a reasonable balance between opportunities and risks. MorphoSys will only take a certain risk if it is accompanied by the opportunity to increase the Companyʼs value.

Revision of the Risk and Opportunity Management System

In the past financial year, the risk and opportunity management system was fundamentally revised and a Group-wide IT solution for the systematic analysis and monitoring of risks and opportunities was introduced. This IT solution supports all responsible risk managers in the monitoring and assessment of risks and opportunities and enables these to be continuously documented. All risks and opportunities are evaluated very closely for a period of one year. Many risks and opportunities, primarily in the area of product development, have more longterm effects, which is also why a three-year period is considered.

Principles of Risk and Opportunity Management

MorphoSys is continually confronted with risks and opportunities. Material effects on assets and the financial situation, as well as a direct impact on intangible assets, such as the Companyʼs image in the industry or the Companyʼs brand, are possible in this regard.

MorphoSys defines risks as internal or external events that have a direct influence on the Company. The potential financial impact on the Companyʼs goals is evaluated here. Opportunities are directly linked with risks. The occurrence of opportunities has a positive influence on the Companyʼs goals, while risks have a negative influence.

Responsibilities in the Risk and Opportunity Management System

The Management Board of MorphoSys AG is responsible for the risk and opportunity management system. It ensures that all opportunities and risks are presented, assessed and monitored in a comprehensive manner. The Corporate Finance & Corporate Development department coordinates their implementation and regularly reports to the Management Board. The Supervisory Board has tasked the Audit Committee with monitoring the effectiveness of the Group’s risk management system. The Audit Committee regularly reports on the results to the whole Supervisory Board.

fig. 14 /// MORPHOSYS’S RISK MANAGEMENT SYSTEM

Accounting-Related Internal Control System

MorphoSys uses extensive internal controls, Group-wide reporting guidelines and additional measures, including employee training and continuous education, with the intention of ensuring accurate bookkeeping and accounting as well as reliable financial reporting in the Consolidated Financial Statements and the Group Management Report. This integral element of the consolidated accounting process comprises preventive, monitoring and detective measures designed to ensure safety and control in accounting and operational functions. For more detailed information about the internal control system regarding financial reporting, please see the Corporate Governance Report.

Risks

RISK MANAGEMENT SYSTEM

The risk management system is a key element of MorphoSysʼs activities in terms of complying with legal requirements and good corporate governance practice.

MorphoSys has established a comprehensive system to identify, assess, communicate and manage risks across all parts of the organization. The risk management system at MorphoSys identifies risks early on and enables appropriate measures in order to limit losses and avoid risks that would threaten the Companyʼs existence. All mitigation measures have been clearly assigned to responsible risk managers, predominantly to members of MorphoSysʼs Senior Management Group.

All major risks for MorphoSysʼs different business units, as well as in terms of the Company as a whole, are assessed within the framework of a systematic risk evaluation process. These risk evaluations are carried out twice a year. Risks are evaluated by comparing their quantifiable impact on the MorphoSys Group and their probability of occurring with and without having established any mitigation processes. The methodology is applied over an assessment period of twelve months and a mid-term view of three years in order to include the long timelines in proprietary development. An overview of the current risk evaluation by MorphoSys is shown in Fig. 15. The risk management system is continuously discussed in and among the Management Board and the Supervisory Board. It is also reviewed on a regular basis by external consultants in order to ensure continuous development so as to react to possible changes at all times.

fig. 15 /// DESCRIPTION OF MAJOR RISKKS AT MORPHOSYS (IN POINTS)

RISK CATEGORIES

MorphoSys has grouped its most important risks in the following six categories:

  • Financial risks (e.g. those resulting from insolvencies, payments not received, lower-than-expected and budgeted license fees, research funding and milestone payments as well as risks associated with any form of financing and financial instruments, e.g. financial investment, currency, interest rates, taxes and receivables collection)
  • Operational risks (e.g. procurement/production, distribution/ logistics, customers, human resources or, especially for MorphoSys, risks resulting from preclinical or clinical studies)
  • Strategic risks (e.g. mergers & acquisitions, shareholdings, research & development, corporate image, superior competitor products)
  • External risks (risks beyond the Companyʼs control, e.g. economic, political, legal risks, especially for companies in biotechnology and pharmaceutical industry also risks regarding intellectual property or regulatory environment risks when new drugs are approved)
  • Organizational risks (e.g. IT, facility management, succession planning, interruption of business, delay in processes due to high complexity or high number of projects)
  • Compliance risks (e.g. non-compliance with the US Food and Drug Administration ( FDA  ) or European Medicines Agency (EMA), guidelines for quality management, accounting rules, corporate governance, abidance of the German Stock Corporation Act)
FINANCIAL RISKS

The Companyʼs financial risk management strategy aims at limiting financial risks and aligning those risks with the requirements of MorphoSysʼs business activities.

Financial risks can arise within the framework of licensing agreements, for example, if projects (products or technologies) are out-licensed late, not at all or for an amount less than planned. A corresponding risk also arises if revenues do not reach the expected amount or increased resource requirements push up costs by more than the sum set out in the budget plan. Detailed project preparation, for example via an intensive exchange with internal and external partners and consultants, guarantees optimal positioning in the run-up and thus also provides an important tool for minimizing risk.

Potential insolvencies of banks are still a financial risk owing to the continued uncertain economic situation. The Company only invests in funds and products considered to be as secure as possible – to the extent that this is possible and assessable – with banks that have consistently high ratings and/or are backed by a very strong partner.

OPERATIONAL RISKS

Operational risks encompass risks with regard to the research and development of proprietary drug candidates, as well as risks in the Central Purchasing and Logistics department, and risks in the recruitment of qualified employees.

A breakdown of a clinical trial – whereby the breakdown of a trial does not necessarily mean the breakdown of an entire program – before out-licensing to partners can arise if clinical data do not demonstrate the expected results or demonstrate unexpected and unwanted side effects. The design of clinical trials and the creation of development plans are always carried out with the greatest care in order to have the best chances of showing results that are significant and convincing to regulatory bodies and potential partners. Besides internal knowledge, external experts are also consulted. Special committees have been created to monitor the progress of clinical programs.

With respect to purchasing and logistics, a partnership is established with suppliers in order to avoid delivery delays, bottlenecks and the accompanying costs. This is supported by regular supplier evaluation, which identifies possible problems, determines solutions and is communicated to the relevant managers, internally as well as externally. Human  Resources risks are mostly related to recruitment processes, e.g. difficulties in recruiting candidates with the skills required for the specific position, or difficulties in keeping employees permanently. In order to counter these risks, MorphoSys’s HR department uses all opportunities to optimize the recruitment process, by means of cooperation with external organizations, among other things. Hiring processes start as early as possible and the Human Resources department develops measures to present MorphoSys as an attractive employer with an open and creative culture.

STRATEGIC RISKS

Risks resulting from missed opportunities may arise due to a lack of access to attractive targets, compounds or innovative technologies. These risks in turn are related to missing or unsuccessful M&A  transactions. In order to counter these risks, a comprehensive assessment process for investment opportunities has been established. Another strategic risk may result from not finding any attractive disease-related target molecules and compounds. Improved identifi cation activities and strategic alliances can facilitate an effective search for suitable building blocks.

EXTERNAL RISKS

External risks for MorphoSys are mainly related to the Companyʼs intellectual property. Patent protection for MorphoSysʼs proprietary technologies is highly important. In order to mitigate risks in this area, MorphoSys continuously searches for and analyzes published patents and patent applications, monitors relevant hits and develops design-around strategies for potentially relevant patents before they are issued.

MorphoSys achieved growing success during the years with this strategy and was able to secure commercial freedom with regard to its proprietary technology platforms in the long term.

Another area in which external risks can arise is changes to regulatory frameworks, which could require MorphoSys to adjust its development plans and activities. To be able to proactively pick up on possible changes in plans that can span several years, MorphoSys has installed industry-standard monitoring systems that introduce measures in a timely fashion and adapt strategies to the changed framework conditions, if appropriate.

ORGANIZATIONAL RISKS

Organizational risks exist in the Partnered Discovery, Technical Operations and IT areas. In the Partnered Discovery department, quality issues or time delays can arise within the organization if the number of programs increases or the programs become increasingly complex. To reduce complexity and thus risks, standard processes have been introduced, the adherence to which is evaluated by means of regular audits.

Risks in the Technical Operations department relate to processes that could lead to adverse effects on, or disruption of, operations as well as incidents with hazardous or environmentally damaging pollutants. To avoid incidents of this kind, tailored measures have been implemented; these include the routine checking and maintenance of equipment and installations as well as education and training sessions for affected employees. Furthermore, tailored electronic monitoring systems minimize such risks. Financial risks affecting this area are largely insured. For further information regarding the operational environment of MorphoSys, please see the Sustainability Report.

In IT, business operations might be at risk due to failures of the IT infrastructure or the IT security system. These risks are countered by multiple daily data backups as well as the implementation of highly secure firewall and virus scan systems to enhance the safety and reliability of the data. Furthermore, MorphoSys minimizes risks relating to the availability, reliability, and efficiency of its IT systems through continuous checkups (e.g. simulated staggered hacker attacks) and updates of its software and hardware systems. Regular reviews and adaptations of the IT strategy are also conducted on a yearly basis.

COMPLIANCE RISKS

Compliance risks can arise if quality standards are not adhered to or are inefficiently handled from a legal viewpoint. As stated in the Sustainability Report, MorphoSys is committed to fulfilling the highest quality standards regarding its business operations. In order to minimize these risks, the system is regularly reviewed by experts, and recurrent audits are performed by an internal Quality Assurance department.

Concrete risks can arise if the internal quality management systems do not comply with legal standards or the implementation of systems for the disclosure of quality defects is neglected. If internal controls were not in a position to disclose breaches of the guidelines on Good Manufacturing Practice ( GMP  ), Good Clinical Practice ( GCP  ) or the Good Laboratory Practice ( GLP  ), this would equally represent a compliance risk.

Incorrectly executed Annual General Meetings can lead to legal disputes with shareholders. The consequences would be signifi - cant costs, either in order to avoid the annulment of the Annual General Meeting or, where this is not possible, to hold the Annual General Meeting a second time. Additionally, possible capital measures to be determined (e.g. a capital increase) would also be endangered.

In order to minimize this risk, the preparation and realization of the Annual General Meeting, as well as all relevant documents and processes, are monitored and inspected in detail by the relevant internal departments in addition to external lawyers and auditors.

THE MANAGEMENT BOARD’S EVALUATION OF THE OVERALL RISK SITUATION AT THE MORPHOSYS GROUP

The Management Board considers the risks to be manageable and the survival of the MorphoSys Group not to be endangered at the time of the current report. This statement is true for all relevant single entities and for the MorphoSys Group as a whole. As already described, MorphoSys regularly monitors its risks via an effective risk management system which is subject to continuous improvements.

Opportunities

MorphoSys possesses leading antibody technologies and a portfolio of promising clinical development candidates. A substantial number of pharmaceutical and biotechnology companies are active in the antibody area and could become future customers and partners for MorphoSysʼs products and technologies. Together with extensive expertise in the area of technology and product development, MorphoSys has identified a range of growth opportunities for the coming years.

MorphoSysʼs antibody technologies offer key advantages for the development and optimization of therapeutic antibody candidates, which could translate into higher success rates in the drug development process.

Opportunities can also arise outside of the antibody segment, in other classes of compound, and through the transfer and application of MorphoSysʼs core competencies in the area of technology. In the 2012 financial year, MorphoSys launched an initiative to seize these opportunities by means of commercial agreements with young companies together with an investment in the same.

GENERAL STATEMENT ON OPPORTUNITIES

Increased life expectancy in industrialized countries as well as the changing economic situation and lifestyle in emerging nations are expected to drive demand for additional and innovative treatment options and enabling technologies. scientific and medical progress has resulted in a better understanding of the biology of several diseases, which in turn paves the way for new therapeutic approaches. Innovative therapies such as fully human antibodies have been launched in recent years and have resulted in the development of commercially successful medical products. In addition, therapeutic compounds based on proteins*, also known as biological compounds or biologics, are considered to be less exposed to competition from generics than traditional, small molecules, mainly because the manufacturing of biologics is much more complex. Therefore, the demand for antibodies and the interest in this class of drugs have increased sharply over the last twelve to 36 months, as shown by several acquisitions and significant licensing agreements in this field.

MARKET OPPORTUNITIES

MorphoSys believes that its technology platforms HuCAL  and Ylanthia  as well as Slonomics  can be applied to make products that address significant and so far unmet medical needs.

THERAPEUTIC ANTIBODIES – PARTNERED DISCOVERY

By pursuing drug development with a variety of partners, MorphoSys has been able to spread the inevitable risks linked to the development of individual drugs. With over 70 therapeutic antibody development programs currently operated with partners, it is increasingly likely that MorphoSys will participate financially in several marketed drugs. In 2012, the first drug candidate – the antibody gantenerumab, which is being developed by the pharmaceutical group Roche in the area of Alzheimerʼs disease – reached the approval-linked third phase of clinical development.

MorphoSys will continue to expand its partnered antibody pipeline. In addition, the company could enter new revenue-generating partnerships.

THERAPEUTIC ANTIBODIES – PROPRIETARY DEVELOPMENT

The pharmaceutical industry is likely to further intensify its inlicensing of new compounds in order to refill pipelines and replace former key products and turnover generators that have lost patent protection. With its most advanced compounds MOR103, MOR202 and MOR208, MorphoSys is in a good starting position to profit from the needs of pharmaceutical groups.

With the Partnered Discovery segment providing a secure cash flow over the coming years, MorphoSys is in a good position to continue to strengthen its proprietary product portfolio. MorphoSys will start additional clinical trials for its key drug candidates, for example by investigating new areas of disease. MorphoSys plans to add programs to its portfolio and could use existing and future co-development opportunities to achieve this. Furthermore, the Company is looking to in-license interesting drug candidates.

TECHNOLOGY DEVELOPMENT

MorphoSys continues to invest in its existing and new technologies to maintain its pole position as a technological leader. With Ylanthia, MorphoSys has established a new technology platform, which – unlike its predecessor HuCAL – is available for broader licensing to partners. In 2012, MorphoSys began the commercialization of the Ylanthia antibody library.

Technological advances of this kind may enable the Company to further expand its list of partners and to increase the speed and success rates of its partnered and proprietary drug development programs. New technology modules could also open up new areas of disease in which antibody-based treatments are underrepresented today by allowing the generation of antibodies against novel classes of target molecules.

Technology development is driven by a team of scientists who concentrate on the development of MorphoSysʼs technologies. In addition to internal technology development, MorphoSys also relies on external sources in order to strengthen its technological capacities. Cooperation with and a shareholding in Lanthio Pharma, a Dutch company that deals with the development of lantipeptides, is a good example of such activities.

ACQUISITION OPPORTUNITIES

MorphoSys has demonstrated its ability to make acquisitions and use these to accelerate its growth. MorphoSys did not make any acquisitions in the past financial year, but did successfully sell substantially all of its business division AbD Serotec in order to focus on drug development. The AbD Serotec segment was strengthened by two acquisitions in 2005 and 2006, and was successfully sold for more than its carrying value to Bio-Rad in December 2012.

MorphoSys continues to consider its acquisition strategy as an attractive means of increasing its market share, supplementing its existing pipeline and technology platform and securing access to patents and licenses for the development of novel proprietary technologies and products.

FINANCIAL OPPORTUNITIES

Favorable exchange rates and interest rate developments can have a positive effect on the Groupʼs financial results. The developments in the interest and financial markets are continuously monitored in order to identify and utilize opportunities promptly.