Risk and Opportunity Report

MorphoSys operates in an industry characterized by constant change and innovation. The challenges and opportunities in the healthcare sector are influenced by a wide variety of factors. Global demographic changes, medical advances and the desire to increase quality of life provide excellent growth opportunities for the pharmaceutical and biotechnology industries; however, companies must also grapple with growing regulatory requirements in the field of drug development as well as cost pressure on the healthcare systems.

MorphoSys makes a great effort to identify new opportunities and to leverage its business success to generate a lasting increase in enterprise value. Entrepreneurial success, however, is not achievable without conscious risk-taking. Through its worldwide operations, MorphoSys is confronted with a number of risks that could affect its business. MorphoSys’s risk management system identifies these risks, evaluates them and takes suitable action to avert risk and reach its corporate objectives. A periodic strategy review ensures that there is a balance of risk and opportunity. MorphoSys only assumes risk when there is an opportunity to increase the Company’s enterprise value.

Risk Management System

The risk management system is an essential element of MorphoSys’s corporate governance and ensures the Company adheres to good corporate governance principles and complies with regulatory requirements.

MorphoSys has a comprehensive system in place to identify, assess, communicate and deal with risks throughout the Company. The risk management system identifies risk at a very early stage, making it possible to take action to limit operating losses and avoid risks that could jeopardize the Company. All actions to minimize risk are assigned to risk officers, most of whom belong to MorphoSys’s Senior Management Group.

All material risks in the various business segments and the Company as a whole are assessed using a systematic risk process that is carried out twice a year. Risks are assessed by comparing their quantifiable financial impact on the MorphoSys Group with their probability of occurrence with and without initiating a risk mitigation process. This method is applied over a 12-month assessment period as well as a period of three years to include risks related to the Company’s proprietary development that have longer durations. Additionally, there is a strategic risk assessment that spans more than three years. An overview of MorphoSys’s current risk assessment activities can be found in Tables 10 and 11.

Risk managers enter their risks into a Group-wide IT platform that makes monitoring, analyzing and documenting risks much easier. The risk management system distinguishes risk owners from risk managers. Risk owners are typically the relevant department heads (usually members of the Senior Management Group). Risk managers can be department employees when the risks that fall under their area of responsibility are included in the risk management system. Risk owners and risk managers are required to update their risks and assessments at half-yearly intervals. The process for this is coordinated and led by the Corporate Finance & Corporate Development Department, which is also responsible for monitoring the evaluation process and summarizing the key information. The information is regularly presented to the Management Board who, in turn, presents the results to the Supervisory Board twice a year. The entire evaluation process is based on standardized forms for the evaluations. Risk management and monitoring activities are carried out by the relevant managers. The changes in the risk profile resulting from these activities are recorded at regular intervals. An audit by external consultants ensures the ongoing development of the risk management system and that any potential changes in the Company’s risk areas are promptly incorporated. The risk and opportunity management system combines a bottom-up approach for recognizing both short- and medium-term risks with a top-down approach in the area of strategic risks and opportunities. The top-down approach systematically identifies global strategic risks and opportunities and completes the overview of the overall risks and opportunities. Examples include environmental and industry risks, personnel risks and other risks that may result from the public perception of the Company. As part of the top-down approach, workshops are held twice per year with selected members of the Senior Management Group. Within these workshops the strategic risks and opportunities in different areas of the Company are assessed and discussed including those exceeding a period of three years. The evaluation process is solely qualitative. These risks are listed in Table 11.

Principles of Risk and Opportunity ­Management

MorphoSys continually encounters both risks and opportunities. These could have a potential material impact on the net assets and financial position as well as a direct effect on intangible assets, such as the Company’s image in the sector or the Company’s trademark.

MorphoSys defines risk as an internal or external event that has an immediate impact on the Company and includes an assessment of the potential financial impact on the Company’s targets. There is a direct relationship between opportunity and risk. Seizing opportunities has a positive influence on Company targets, whereas risk emergence has a negative influence.

Responsibilities Under the Risk and ­Opportunity Management System

The Management Board of MorphoSys AG is responsible for the risk and opportunity management system and ensures that all risks and opportunities are evaluated, monitored and presented in their entirety. The Corporate Finance & Corporate Development Department coordinates the implementation of actions and reports regularly to the Management Board. The Supervisory Board has appointed the Audit Committee to monitor the effectiveness of the Group’s risk management system. The Audit Committee periodically reports its findings to the entire Supervisory Board, which is also directly informed by the Management Board twice a year.

16 figure Risk and Opportunity Management System at MorphoSys

Accounting-Related Internal Control System

MorphoSys employs extensive internal controls, Group-wide reporting guidelines as well as other measures, such as employee training and ongoing professional education with the goal of maintaining accurate bookkeeping and accounting and ensuring reliable financial reporting in the consolidated financial statements and group management report. This essential component of Group accounting consists of preventative, monitoring and detection measures intended to ensure security and control in accounting and operating functions. Detailed information about the internal control system for financial reporting can be found in the Corporate Governance Report.

Risks

RISK CATEGORIES

MorphoSys divides its key risks into the following six categories.

  • Financial risk (includes risk resulting from insolvencies and payment defaults; license fees; research funding and milestones that are lower than planned or anticipated; and risks associated with any form of financing and financial instruments, such as cash investments, bank failures, currencies, (negative) interest rates, taxes, debt collection and lack of funding)

  • Operational risk (risk, for example, in the areas of procurement/production, customers and personnel, as well as risk related to preclinical or clinical trial results and other risk specific to the biotechnology industry)

  • Strategic risk (for example mergers and acquisitions (M&A), shareholdings, R&D, corporate image, superior development projects and technologies of competitors and portfolio development)

  • External risk (risk beyond the Company’s control, such as economic, political and legal risk; as well as risk specific to companies in the biotechnology and pharmaceutical industries, such as the risk to intellectual property protection or in the regulatory environment when seeking the approval of new drugs)

  • Organizational risk (includes risk concerning IT, facilities management, succession planning, business interruption and process delays as a result of the high complexity and number of projects)

  • Compliance risk (for example, non-compliance with US FDA and European EMA regulations, quality management policies, accounting standards, corporate governance or violations of the German Stock Corporation Act)

FINANCIAL RISK

MorphoSys’s financial risk management seeks to limit financial risk and reconciles this risk with the requirements of its business.

Financial risk can arise in relation to licensing agreements, for example when projects (products or technologies) do not materialize, are delayed or out-licensed to a different degree than originally planned. Risk also arises when revenues do not reach their projected level or when costs are higher than planned due to higher resource requirements. Detailed project preparations, such as those made through in-depth exchanges with internal and external partners and consultants, ensure the optimal starting point early in the process and are important for minimizing risk. Financial risk related to the Company’s proprietary programs was reduced in 2013 by successfully partnering MOR103/GSK3196165. The financial risk relating to the fully proprietary programs MOR202 and MOR208 remains entirely with MorphoSys. MorphoSys retains some risk with respect to the clinical development of programs introduced into partnerships; for example, MOR106 and MOR209/ES414. The early termination of development partnerships may force MorphoSys to bear future development costs alone and have a major impact on the Company’s income statement and financial planning.

Continuing economic difficulties in Europe indicate that potential bank insolvencies still pose a financial risk. For this reason, MorphoSys continues to invest only in funds and bank instruments deemed safe – to the extent this is possible and can be estimated – and that have maintained their high rating and/or are secured by a strong partner. MorphoSys has simulated various scenarios and set up appropriate contingency plans. A further risk is the receipt of adequate interest on financial investments, particularly in light of today’s negative key interest rates.

In future, MorphoSys will continue to spend substantial resources on the development of product candidates, including the identification of target molecules and drug candidates, the conducting of preclinical studies and clinical trials, the manufacturing of material and the support of collaborations and joint development of programs as well as the acquisition of new technologies and the in- licensing of new development candidates. The current financial resources and expected future cash in-flows should be sufficient to meet the Company’s current and near-term capital requirements. However, it is not guaranteed that funding will be sufficient in the long term at all times.

OPERATIONAL RISK

Operational risk includes risks related to the exploration and development of proprietary drug candidates.

The termination of a clinical trial prior to out-licensing to partners – which does not necessarily imply the failure of an entire program – can occur when the trial data does not produce the expected results, shows unexpected adverse side effects or is compiled incorrectly. Clinical trial design and drafts of development plans are always completed with the utmost care. This gives the trials the best opportunity to show clinically relevant data in clinical testing and persuade regulatory agencies and potential partners. External experts also contribute to the Company’s existing internal know-how. Special steering committees and panels are formed to monitor the progress of clinical programs.

Antibody production is a significant cost factor in the development of drugs. The Company’s obligation to comply with international drug regulatory agencies’ requirements at every step of production in order to ensure the highest quality compounds and patient safety plays a critical role in its costs. The production process for biopharmaceuticals is usually performed in cell culture systems with several thousand liters of culture volume and requires a number of steps to be carried out under strict supervision and controlled conditions until the individual investigational medicinal products are ready for use in patients. Therefore, depending on the phase of the project, lead times of up to one to two years must be scheduled for the supply of antibody material. This planning, coupled with early strategic financial investments, represent major factors in drug development because of the high complexity and risk involved in both the production process and clinical trial planning, which can have a considerable effect on the speed and cost of development.

Any changes with respect to clinical trials such as the trial’s design or the speed at which patients can be recruited can have a negative impact on the trial’s economic feasibility and potential. Such a case occurred at the end of 2016 when MorphoSys recognized a partial impairment on the carrying amount of MOR209/ES414 due to a significant delay in recruiting patients.

Operational risk can arise from the non-renewal of the cooperation agreement with Novartis. The current agreement ends end of November 2017. Novartis has the option to extend this agreement for an additional two years. Should Novartis decide not to exercise this option, MorphoSys would stand to lose annual revenues of approximately € 40 million as of the 2018 financial year. At this time, MorphoSys believes that the contract with Novartis will not be extended.

STRATEGIC RISK

Access to sufficient financing options also poses a strategic risk for the Company. Following MorphoSys’s decision to develop its proprietary portfolio in-house, the financing of research and development is now a key focus. Risks in this respect can arise from a lack of access to capital. MorphoSys mitigates these risks by forming multidisciplinary teams responsible for overseeing the budget when adding to the proprietary portfolio. The Company also employs various departments and external consultants to ensure the smooth execution of capital market transactions.

A further strategic risk is the danger that a development program introduced into a partnership may fail. Partnerships can be terminated prematurely, forcing MorphoSys to search for new development partners or bear the substantial cost of further development alone. This may result in a delay or even the termination of the development of individual candidates and could lead to additional costs and a potential long-term loss of revenue for MorphoSys due to delayed market entry. The termination of our partnership with Celgene for MOR202 is an example of the type of risk described.

Another strategic risk is that missed M&A opportunities or failed M&A transactions could block access to strategically important assets. To minimize this risk, MorphoSys has a number of qualified teams who screen the market to ensure that MorphoSys does not miss any acquisition opportunities.

EXTERNAL RISK

MorphoSys faces external risk with respect to intellectual property, among others. The patent protection of MorphoSys’s proprietary technologies and compounds is especially important. To minimize risks in this area, MorphoSys keeps a vigilant eye on published patents and patent applications and analyzes the corresponding results. The Company also develops strategies to circumvent external patents that may one day be relevant before they are issued or takes other appropriate action. Through the years, MorphoSys has seen increasing success with this strategy and has created ample leeway for its proprietary technology platforms and products for many years to come. Risks can also arise from enforcing the Company’s patents against third parties. External risks can also emerge from changes in the regulatory environment. These risks are minimized by providing ongoing training to the relevant personnel and by audits and discussions with external experts. It is also conceivable that competitors challenge patents of MorphoSys Group companies or that MorphoSys concludes that MorphoSys’s patents or patent families are infringed by competitors, which may prompt MorphoSys to take legal action against competitors. This type of legal action, particularly when it occurs in the USA, involves high costs and poses a significant financial risk.

As an internationally operating biotechnology company with numerous partnerships and an in-house research and development department for developing drug candidates, the MorphoSys Group is subject to a number of regulatory and legal risks. These risks include those related to patent, competition, tax and antitrust law, potential liability claims from existing partnerships and environmental protection. The Regulatory Affairs department is also affected by this risk in terms of the feedback it receives from regulators on study design. Future legal proceedings are conceivable and cannot be anticipated. Therefore, we cannot rule out that we may incur expenses for legal or regulatory judgments or settlements that are not or cannot be partially or fully covered by insurance and may have a significant impact on our business and results.

ORGANIZATIONAL RISK

The Proprietary Development and Technical Operations areas, among others, are subject to organizational risk. Proprietary Development may face quality problems or delays within the organization if the number of programs or their complexity increases. To reduce complexity and thereby reduce risk, the Company introduced uniform procedures and monitors their compliance by means of routine audits.

Risk in the Technical Operations area concerns procedures that may cause lasting damage, business interruptions or accidents involving harmful or polluting substances. Measures taken to avoid these types of disruptions include the routine inspection and maintenance of equipment and facilities and providing training and tutorials for the employees concerned. These risks are reduced even further using electronic monitoring systems. Financial risk in this area is generally covered by insurance. Additional information on MorphoSys’s operating environment can be found in the section “Sustainable Business Development.”

COMPLIANCE RISK

Compliance risk can arise when quality standards are not met or business processes are not conducted properly from a legal standpoint. To counter this risk, MorphoSys is committed to having its business operations meet the highest quality standards as set out in the Sustainability Report. The system is also routinely checked by external specialists and subjected to repeat testing by an internal, independent in-house quality assurance department.

Specific risk can arise, for example, when the internal quality management system does not meet the legal requirements or when there is no internal system for detecting quality problems. If the internal controls are not able to detect violations of Good Manufacturing Practice (GMP), Good Clinical Practice (GCP) or Good Laboratory Practice (GLP) then this also would represent a compliance risk.

Inadequate or late financial communication can lead to fines or even lawsuits. Annual General Meetings conducted incorrectly may lead to legal disputes with shareholders resulting in significant costs from attempts to prevent either a challenge to or repeat of the Annual General Meeting. Pending decisions for corporate actions, such as capital increases, could also be compromised. To minimize these risks, the preparation and execution of the Annual General Meeting and all related documents and processes are carefully reviewed and monitored by the relevant internal departments as well as external lawyers and, regarding the annual report, by the auditors.

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

MorphoSys Group’s Management Board considers the overall risk to be appropriate and trusts in the effectiveness of the risk management system in relation to changes in the environment and the needs of the ongoing business. It is the Management Board’s view that the MorphoSys Group’s continued existence is not jeopardized. This assessment applies to the MorphoSys Group as a whole as well as to each Group company. This conclusion is based on several factors that are summarized as follows:

  • The MorphoSys Group has an exceptionally high equity ratio.

  • The Management Board firmly believes that the MorphoSys Group is well positioned to cope with any adverse events that may occur.

  • The Group participates in a comprehensive portfolio of preclinical and clinical programs in partnerships with a number of large pharmaceutical companies and has a strong base of technologies for expanding the Company’s proprietary portfolio.

Despite these factors, it is impossible to rule out, control or influence risk in its entirety.

Opportunities

Leading antibody technologies, excellent know-how and a broad portfolio of validated clinical programs have made MorphoSys one of the world’s leading biotechnology companies in the field of therapeutic antibodies. This therapeutic class is now one of the most successful in the industry, and there is an impressive number of pharmaceutical and biotechnology companies in the field of antibodies that could potentially become customers or partners for MorphoSys’s products and technologies. Due to this fact and thanks to the Company’s extensive technological and product development expertise, MorphoSys has identified a number of future growth opportunities.

MorphoSys’s technologies for developing and optimizing therapeutic antibody candidates have distinct advantages that can lead to higher success rates and shorter development times in the drug development process. The transfer and application of MorphoSys’s core capabilities – even those outside of the field of antibodies – opens up new opportunities for the Group because many classes of compounds have similar molecular structures. The Innovation Capital initiative seizes previously unavailable opportunities by making MorphoSys a strategic investor in young, innovative companies and allowing it to use synergies effectively.

OPPORTUNITY MANAGEMENT SYSTEM

The opportunity management system is an important component of MorphoSys’s corporate management and is used to identify opportunities early and generate added value for the Company.

Opportunity management is based on four pillars:

  • a routine discussion forum involving the Management Board and selected members of the Senior Management Group,

  • the Company’s business development activities,

  • a technology scouting team, and

  • the Innovation Capital initiative.

Committees discuss specific opportunities and decide what action should be taken to exploit these opportunities. The meetings and their outcomes are recorded in detail, and any subsequent action is reviewed and monitored. The Group’s Business Development Team takes part in numerous conferences and in the process identifies different opportunities that can enhance the Company’s growth. These opportunities are presented and evaluated within the committee using an evaluation process. The Technology Scouting Team searches specifically for innovative technologies that can generate synergies with MorphoSys’s technological infrastructure and identify new therapeutic molecules. These outcomes are also discussed and evaluated in interdepartmental committees. The Innovative Capital initiative already described also allows MorphoSys to participate in these early innovations and make it possible for the Company to use them in the future. A proven process for evaluating opportunities gives MorphoSys a qualitative and replicable evaluation.

GENERAL STATEMENT ON OPPORTUNITIES

Increased life expectancy in industrialized countries and rising incomes and living standards in emerging countries are expected to drive the demand for more innovative treatment options and advanced technologies. Scientific and medical progress has led to a better understanding of the biological process of disease and paves the way for new therapeutic approaches. Innovative therapies, such as fully human antibodies, have reached market maturity in recent years and have led to the development of commercially successful medical products. Therapeutic compounds based on proteins – also referred to as “biologics” – are less subject to generic competition than chemically produced molecules because the production of biological compounds is far more complex. The sharp rise in both the demand for antibodies and the interest in this class of drug candidates can be seen by the acquisitions and significant licensing agreements made over the past two to three years.

MARKET OPPORTUNITIES

MorphoSys believes its antibody platforms HuCAL, Ylanthia, ­Slonomics and the in-licensed lanthipeptide technology can all be used to develop products addressing high unmet medical needs.

THERAPEUTIC ANTIBODIES – PROPRIETARY DEVELOPMENT

It is reasonable to assume that the pharmaceutical industry will increase the level of in-licensing new drugs to refill its pipelines and replace key products and blockbusters that have lost patent protection. MorphoSys’s most advanced compounds MOR103/GSK3196165, MOR202 and MOR208 place the Company in an ­excellent position to capitalize on the needs of pharmaceutical companies.

Secured cash flows from the Partnered Discovery segment have allowed MorphoSys to strengthen its proprietary portfolio continuously. By investigating new disease areas, MorphoSys will continue to expand its proprietary portfolio by adding clinical trials using the Company’s key drug candidates. MorphoSys intends to enhance its portfolio with additional programs and in doing so could take advantage of existing and future opportunities for co-development or partnerships. The Company is also looking for more opportunities to in-license interesting drug candidates.

Drug candidates MOR208 and MOR202 may give MorphoSys its first opportunity to market a drug on its own.

THERAPEUTIC ANTIBODIES – PARTNERED DISCOVERY

By developing drugs with a number of partners, MorphoSys has been able to spread the risk inextricably linked with drug development over a broader spectrum. With 100 individual therapeutic antibodies currently in partnered development programs, it is becoming more likely that MorphoSys will have an opportunity to participate financially in marketed drugs. Our partner Janssen, for example, submitted an application to the US Food and Drug Administration (FDA) in November of 2016 to receive regulatory approval for guselkumab.

TECHNOLOGY DEVELOPMENT

MorphoSys continues to invest in its existing and new technologies to defend its technological leadership. MorphoSys established a new technology platform with Ylanthia that, in contrast to its previous version HuCAL, is eligible for broader licensing to different partners. Commercialization of the Ylanthia antibody library began in 2012.

These types of technological advances can help the Company expand its list of partners and increase not only the speed but also the success rate of its partnered and proprietary drug development programs. New technology modules that enable the production of antibodies against novel classes of target molecules can also provide access to new disease areas in which antibody-based treatments are underrepresented.

Technology development is carried out by a team of scientists whose focus is the further development of MorphoSys technologies. MorphoSys not only develops technology internally but also uses external resources to enhance its own activities. A good example of this is the Company’s acquisition of Lanthio Pharma, a Dutch company developing lanthipeptides.

ACQUISITION OPPORTUNITIES

In the past, MorphoSys has proven its ability to acquire compounds and technologies that accelerate its growth. Potential acquisition candidates are also systematically presented, discussed and evaluated during the routine meetings described above between the Management Board and selected members of the Senior Management Group. After these meetings, promising candidates are reviewed in terms of their strategic synergies and evaluated by internal specialist committees. Protocols are completed on all candidates and evaluations are systematically archived for follow-up and monitoring. A proprietary database helps administer this information and keep it available.

MorphoSys plans to move forward with its acquisition strategy in the year ahead in order to enhance its existing portfolio and technology platform and secure access to patents and licenses for novel proprietary technologies and products.

FINANCIAL OPPORTUNITIES

Exchange rate and interest rate developments can positively or negatively affect the Group’s financial results. Interest rate and financial market developments are continuously monitored to promptly identify and take advantage of opportunities.

10 table Summary of Key Short- and Medium-Term Risks at MorphoSys

1-Year Assessment 3-Year Assessment
Financial risk    
Risk of missing revenue targets/incorrect budgeting ••• High ••• High
Risk of lower interest rates and bank insolvencies •• Moderate •• Moderate
   
Operational risk    
Risk related to development of proprietary antibodies ••• High ••• High
Risk related to non-extension of cooperation agreement with Novartis (financial loss) •• Moderate Low
   
Strategic risk    
Risk of failure to receive financing Low •• Moderate
Risk of missed acquisition opportunities Low •• Moderate
   
External risk    
Patent-related risk (related to lawsuits, patent situation of technology platform,
new national/international regulations)
•• Moderate •• Moderate
Risk related to regulatory provisions Low Low
   
Organizational risk    
Risk due to growing number and complexity of programs •• Moderate •• Moderate
Risk in the technical operations area Low Low
   
Compliance risk    
Quality risk related to legal requirements •• Moderate •• Moderate
Legal risk Low Low
Legend
Low risk: low probability of occurrence, low impact
•• Moderate risk: moderate probability of occurrence, moderate impact
••• High risk: moderate probability of occurrence, moderate to strong impact
•••• Catastrophic risk: high probability of occurrence, severe impact

11 table Summary of Key Long-Term Risks at MorphoSys

Segment Risk Order of Importance1
Proprietary Development Lack of competitiveness of the MorphoSys pipeline 1
Partnered Discovery Delay or termination of partnered programs 2
Proprietary Development Lack of funding for the MorphoSys pipeline 3
Proprietary Development Insufficient expansion of the MorphoSys pipeline 4
Proprietary Development Inability to build a sales structure 5
1
Declining importance of risk from 1 to 5, whereby 1 represents the most important risk.
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