SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended March 31,June 30, 2004

Or

For the transition period from            to            

Commission file number: 000-30975

TRANSGENOMIC, INC.

(Exact name of registrant as specified in its charter)

(402) 452-5400

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 daysdays.    Yes  x    No  ¨

Indicate by check mark whether the registrant is accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934,    Yes  ¨    No  x

As of May 7,August 13, 2004, the number of shares of common stock outstanding was 29,044,514.29,070,651.

TRANSGENOMIC INC.

INDEX

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

Transgenomic, Inc. and Subsidiaries

Consolidated Balance Sheets (Unaudited)

(In thousands except share and per share data)

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

Transgenomic, Inc. and Subsidiaries

Consolidated Statements of Operations (Unaudited)

(In thousands except share and per share data)

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

Transgenomic, Inc. and Subsidiaries

Consolidated StatementStatements of Cash Flows (Unaudited)

(In thousands)

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

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(Columar Amounts thousands except share and per share data)

A. CONSOLIDATED FINANCIAL STATEMENTS

The accompanying unaudited consolidated financial statements of Transgenomic, Inc. and Subsidiaries (the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. In the opinion of management of the Company, all adjustments (consisting of only normal and recurring accruals) have been made to present fairly the financial positions, the results of operations and cash flows for the periods presented. The results of operations for the threesix months ended March 31,June 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year. Although the Company believes that the disclosures are adequate to make the information presented not misleading, these financial statements should be read in conjunction with the consolidated financial statements for the period ended December 31, 2003, that are included in the Company’s Annual Report on Form 10-K.

Revenue Recognition.

Revenue on the sales of products is recognized in accordance with the terms of the sales arrangement. Such recognition is based on receipt of an unconditional customer order and transfer of title and risk of ownership to the customer, typically upon shipment of the product. Our sales terms do not provide for the right of return unless the product is damaged or defective. Revenues from certain services associated with our analytical instruments, to be performed subsequent to shipment of the products, is deferred and recognized when the services are provided. Such services, mainly limited to installation and training services that are not essential to the functionality of the instruments, typically are performed in a timely manner subsequent to shipment of the instrument. The Company also enters into various service contracts that cover installed WAVEautomated instrument systems. These contracts cover specific time periods and revenue associated with these contracts is deferred and recognized over the service period.

During the first quarter of fiscal 2004, the Company recognized approximately $196,000 of product sales under bill-and-hold arrangements. Under these arrangements, the customer had accepted title and risk of ownership to the product, but had requested that the Company store the product on behalf of the customer, in a rented freezer, until the second quarter of fiscal2004.

During the second quarter of 2004, the Company recognized approximately $450,000 of product sales under bill-and-hold arrangements. Under these arrangements, the customer had accepted title and risk of ownership to the product, but had requested that the Company store the product on behalf of the customer, in a rented freezer, until the third quarter of 2004.

Stock Based Compensation.

The Company accounts for its employee stock option grants under the provisions of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, which utilizes the intrinsic value method. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company’s common stock at the date of grant over the stock option exercise price. Stock option grants to nonemployees are accounted for using the fair value method of accounting in accordance with Statement of Financial Accounting Standards (SFAS) No. 123,Accounting for Stock-Based Compensation, using the Black-Scholes model.

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123,Accounting for Stock-Based Compensation, to stock based employee compensation.

B. INVESTMENTS

As of December 31, 2003, the Company had no available-for-sale securities. The amortized cost of available-for-sale securities and their approximate fair values as of March 31,June 30, 2004, were as follows:

In January and March 2004, the Company entered into addendums to an existing supply agreement with Geron Corporation. The addendums allowed Geron to pay for products being manufactured by the Company under the addendum with Geron common stock. These shares are being accounted for as available for sale securities. As a result, in January 2004 Geron issued 85,885 shares of common stock, valued at $959,000, to the Company as a prepayment for products. On February 12, 2004 the company sold these shares for $932,000 resulting in a loss of $27,000, which is reflected in the current earnings and cash flow from operations. In March 2004, Geron issued 33,662 shares of common stock, valued at $289,000, to the Company as a prepayment for products.

Transgenomic, Inc. and Subsidiaries

Notes In April, Geron issued 140,872 shares of common stock valued at $1,288,000, to the Consolidated Financial Statements (Unaudited)

(In thousands except shareCompany as payment and per share data) (Continued)prepayment for product. These shares are being accounted for as available for sale securities.

C. INVENTORIES

At March 31,June 30, 2004, and December 31, 2003, inventories consisted of the following:

D. OTHER ASSETS

At March 31,June 30, 2004, and December 31, 2003, finite lived intangible assets and other assets consisted of the following:

Amortization expense for intangible assets was $243,000 and $218,000$200,000 during the three months ended March 31,June 30, 2004 and 2003, respectively, and $486,000 and $418,000 during the six months ended June 30, 2004, and 2003, respectively. The Company expects amortization expense for intangible assets to be approximately $830,000$588,000 for the remainder of 2004, $1,022,000 in fiscal 2005, $367,000 in fiscal 2006, $377,000 in fiscal 2007, $77,000 in fiscal 2008, and $104,000 in fiscal 2009 and $104,000 in fiscal 2010.

E. GOODWILL

At March 31,June 30, 2004, and December 31, 2003, goodwill by operating segment consisted of the following:

Transgenomic, Inc.During the three months ended March 31, 2004, the Company’s Board of Directors directed management to explore strategic alternatives for the Nucleic Acids operating segment. The ongoing process has included significant due diligence by management, its advisors and Subsidiariesprospective independent buyers and other interested parties.

Notes

Based upon information obtained through this process during the three months ended June 30, 2004, management determined that it was more likely than not that the assets of the Nucleic Acids business were impaired. Accordingly, the Company engaged an external valuation firm to assist with the completion of a mid-year impairment test. As a result, the Company recorded a non-cash charge of $11,964,387 related to its Nucleic Acids segment during the three months ended June 30, 2004. The charge consisted of $9,864,387 related to the Consolidated Financial Statements (Unaudited)

(In thousands except shareimpairment of goodwill and per share data) (Continued)$2,100,000 related to the impairment of property and equipment.

F. STOCKHOLDERS’ EQUITY AND STOCK OPTIONS

Other Comprehensive Income.Results of operations for the Company’s foreign subsidiarysubsidiaries are translated using the average exchange rates during the period. Assets and liabilities are translated at the exchange rate in effect on the balance sheet dates. These translation adjustments, along with unrealized gains and losses on available-for-sale securities, are the Company’s only components of other comprehensive income.

Stock Options.During the threesix months ended March 31,June 30, 2004, the Company granted 120,000360,000 options with an exercise price of $1.32 to $2.57 per share. The following table summarizes activity under the 1997 Stock Option Plan during the threesix months ended March 31,June 30, 2004.

The weighted average fair value of options granted during the first threesix months of fiscal 2004 was $1.34 per share. The fair value of each stock option granted is estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for options granted in the first threesix months of fiscal 2004: no common stock dividends; risk-free interest rates of 3.84%4.14% to 4.37%4.79%; 85% volatility; and an expected option life of 3 years. At March 31,June 30, 2004, the weighted average remaining contractual life of options outstanding was 6.26.1 years.

G. COMMITMENTS AND CONTINGENCIES

Subsequent to June 30, 2004, the Company received notification of a lawsuit from a prospective distributor located in Spain. The plaintiff claims breach of promise associated with negotiations for a geographic-specific distributorship and are seeking monetary relief of approximately $500,000.

The Company is subject to a number of other claims for various amounts, which arise out of the normal course of its business. In the opinion of management, the disposition of claims currently pending will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

H. INCOME TAXES

The Company’s tax expense (benefit) relates to its operations in certain foreign countries and certain states. The tax benefit recorded in the second quarter of 2004 relates to payments in the United Kingdom. Due to the Company’s cumulative losses, expected losses in future years and inability to utilize any additional losses as carrybacks, the Company has not provided for an income tax benefit during the threesix months ended March 31,June 30, 2004, based on management’s determination that it was more likely than not that such benefits would not be realized. The Company will continue to assess the recoverability of deferred tax assets and the related valuation allowance. To the extent the Company begins to generate taxable income in future periods and it determines that such valuation allowance is no longer required, the tax benefit of the remaining deferred tax assets will be recognized at such time. As of March 31,June 30, 2004, and December 31, 2003, the Company’s deferred tax assets were offset by a valuation allowance of approximately $32.1$38.0 million and $30.6 million, respectively.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data) (Continued)

H.I. OPERATING SEGMENT AND GEOGRAPHIC INFORMATION

The Company’s operations are managed based upon the nature of the products and services provided. Accordingly, the Company has determined that it operates in two segments, BioSystems and Nucleic Acids. Operations for these segments are evaluated based upon specific identification of revenues and expenses associated with the business activities resulting in segment operating income (loss). Expenses that cannot be directly identified to an operating activity or are considered corporate overhead are not allocated to the segments in arriving at operating income (loss) for the segment. Generally, decisions regarding asset allocation, financing, or other items impacting the Company’s balance sheet are made at the corporate level and, accordingly, balance sheet information is not typically reviewed by operating segment.

The BioSystems operating segment generates revenue from the sale of automated instrument systems and associated consumable products and services. This segment’s products are based upon separations chemistries and enzymology. Specifically, this segment’s main products are the WAVE System, related bioconsumables and research services.

The Nucleic Acids operating segment generates revenue from the sale of products and services based upon nucleic acid chemistries, separations chemistries and enzymology. Specifically, this segment’s main products are nucleic acid building blocks or phosphoramidites, oligonucleotides, fluorescent markers, dyes and associated reagents and novel chemistry and process development services.

The following is information for net sales and operating income (loss) by segment.

I.J. LINE OF CREDIT AND LONG-TERM DEBT

In December 2003, the Company entered into a new, $7.5 million line of credit facility with Laurus Master Fund, Ltd. (“Laurus”). The term of the agreement is three years carrying an interest rate of 2.0% over the prime rate or a minimum of 6.0%. Funds available under the line are are determined by a borrowing base equal to 90% of eligible accounts receivable balances plus up to $1.0 million related to inventory balances. This line of credit is secured by most of the Company’s assets. Payment of interest and principal can, under certain circumstances, be made with shares of the Company’s common stock at a fixed conversion price of $2.20 per share. Conversion of this debt to common stock may be made at the election of Laurus or the Company. The Company may elect to convert only if its

shares trade at a price exceeding $2.42 per share for ten consecutive trading days and such conversion is further subject to trading volume limitations and a limitation on the total beneficial ownership by Laurus of the Company’s common stock. In connection with the line of credit facility, the Company issued warrants to Laurus to acquire 550,000 shares of its common stock at exercise prices that exceed the average trading price of the Company’s common stock over the ten trading days prior to execution of the new line of credit.

In February 2004, the Company entered into a separate $2.75 million convertible note with Laurus,.Laurus. The note carries an interest rate of 2.0% over the prime rate or a minimum of 6.0% and has a term of 3 years. The principal and interest on the note may be converted into common stock of the Company at a fixed conversion price of $2.61 per share. In connection with this agreement, the Company issued 125,000 warrants to Laurus to acquire 125,000 shares of its common stock. A portionstock at exercise prices that exceed the average trading price of the Company’s common stock over the ten trading days prior to the execution of the note. Portions of the proceeds from this transaction were used to retire the mortgage debt on the Company’s Glasgow facility. The remaining proceeds of approximately $750,000 will bewere used to completefurther the build-out of the Glasgow facility, complete the consolidation ourof operations into the new facility and provide funds for operations.

Certain features of the line of credit facility and convertableconvertible note require the Company to separately account for the value of certain amounts related to the warrants issued and the conversion feature of the facility. Specifically, Emerging Issues Task Force (“EITF”) No. 00-27,Application of Issue No. 98-5 to Certain Convertible Instruments, requires the Company to separately value the warrants issued and the “beneficial conversion premium” related to these agreements. Any borrowings under the line of credit facility may result in additional beneficial conversion premiums. The value of the warrants and the beneficial conversion premium have been recorded on the balance sheet as a debt discount and an increase to additional paid in capital. The debt discount recorded for these items will be amortized as expense to the income statement over the term of the facility or as the warrants are exercised or the debt is converted into common stock thereby increasing the effective interest rate on these agreements.

In February 2004, Laurus waived the borrowing base limitation on the Company’s line of credit, thereby making the full $7.5 million facility available to the Company regardless of the available collateral. The waiver will expire on December 19, 2004. As of March 31,June 30, 2004, the Company had approximately $4.4$6.6 million outstanding on this line of credit facility. In January and February 2004, Laurus exercised its conversion rights on the line of credit and converted $2.0 million of amounts outstanding on the line into approximately 910,000 shares of common stock of the Company. In connection with the conversion of $2.0 million of debt incurred under the line of credit facility in January and February 2004, the Company has accelerated the amortization of approximately $460,000$539,000 of the beneficial conversion premium.

The following table details the components of the Company’s line of credit and long-term debt as of March 31,June 30, 2004 and December 31, 2003.

J.K. CORPORATE RESTRUCTURING

The Company has historically experienced net losses and negative cash flows from operations. As a result, during the fourth quarter of fiscal 2002, management formulated a restructuring plan designed to reduce expenses thereby better aligning the Company’s expense structure with current business prospects. The plan included employee terminations, office closures, and termination of collaborations and write-offs of abandoned intellectual property. A significant portion of the plan was executed in the fourth quarter of 2002 resulting in the recording of $3.3 million in restructuring charges. The Company had accrued expenses and other liabilities associated with the restructuring activities of approximately $136,000$59,000 and $227,000 at March 31,June 30, 2004, and December 31, 2003, respectively. The accrued expenses at March 31,June 30, 2004, were related to lease payments associated with office closures.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with our consolidated financial statements and notes included elsewhere in this filing.

Overview

We provide innovative products and services for the synthesis, purification and analysis of nucleic acids. We develop, assemble, manufacture and market our products and services to the life sciences industry to be used in research focused on molecular genetics of humans and other organisms. Such research could lead to development of new diagnostics and therapeutics. Our products can be used to analyze DNA or RNA at the molecular level, amplify, separate, and isolate nucleic acid fragments of particular interest and synthesize conventional or chemically-modified nucleic acid molecules. These capabilities are central to research seeking to discover and understand variations in the genetic code, the relationship of these variations to disease and, ultimately, to develop diagnostics and therapeutics based on this understanding. Our business plan is to participate in the value chain associated with these activities by providing key technology, tools, consumables, biochemical reagents and services to those entities engaged in basic biomedical research and the development of diagnostics and therapeutic agents.

The Company’s operations are managed based upon the nature of the products and services provided. Accordingly, the Company has determined that it operates in two segments, BioSystems and Nucleic Acids. Operations for these segments are evaluated based upon specific identification of revenues and expenses associated with the business activities resulting in a segment operating income. Expenses that cannot be directly identified to an operating activity or are considered corporate overhead are not allocated to the segments in arriving at operating income for the segment.

The BioSystems operating segment generates revenue from the sale of automated instrument systems and associated consumable products and services. This segment’s products are based upon separations chemistries and enzymology. Specifically, this segment’s main products are the WAVE System, related bioconsumables and research services. Since the WAVE System product introduction in 1997, we have sold over 1,0001,100 instruments to customers in over 30 countries.

The Nucleic Acids operating segment generates revenue from the sale of products and services based upon nucleic acid chemistries, separations chemistries and enzymology. Specifically, this segment’s main products are nucleic acid building blocks or phosphoramidites, oligonucleotides, fluorescent markers, dyes and associated reagents and novel chemistry and process development services.

We have incurred significant losses resulting principally from costs incurred in research and development and selling, general and administrative costs associated with our operations.costs. At March 31,June 30, 2004, we had an accumulated deficit of $76.6$91.7 million. We expect to continue to incur substantial research and development and selling, general and administrative costs.

Executive Summary

The following is a summary of significant items or events that have had an effect on the Company’s financial position, results of operations, and liquidity during the quarter:

Based upon information obtained through this process during the three months ended June 30, 2004, we determined that it was more likely than not that the assets of the Nucleic Acids business were impaired. Accordingly, we engaged an external valuation firm to assist with the completion of a mid-year impairment test. As a result, we recorded a non-cash charge of $11,964,387 related to our Nucleic Acids segment during the three months ended June 30, 2004. The charge consisted of $9,864,387 related to the impairment of goodwill and $2,100,000 related to the impairment of property and equipment.

In addition to the efforts described above related to the Nucleic Acids operating segment, we are currently assessing multiple options to enhance liquidity and working capital. Among other things, we have adopted a process to improve our liquidity position, including:the collection of receivables, we are evaluating alternatives to continue to reduce operating expenses, and we are exploring additional capital sources.

Results of Operations Three Months Ending March 31,June 30, 2004 and 2003

Three Months Ended March 31, 2004 and 2003

Net Sales. Sales in our BioSystems operating segment decreased in the firstsecond quarter of 2004 compared to the firstsecond quarter 2003. Bioinstruments revenues were significantly lower than 2003, but this decrease was partially offset by increased sales in our Discovery Services. The decline in systems sales is mainly due to continued low sales volumes toweak demand from our North American customer base. Increased services revenue is attributable to our focusactivities focused on providing genetic variation discovery and analysis services to oura pharmaceutical base of customers. We believe that our genetic variation discovery and analysis services provide us a significant opportunity to expand revenues in the future. In December 2003, we announced aan ongoing revenue opportunity. A discovery servicesservice agreement with Novartis Pharmaceuticals Corp. supporting the clinical development of oncology therapeutics and believe this provideshas provided a good model of the opportunitytemplate to utilize for our services offering. Bioconsumable product sales strengthened from increased WAVE related consumable usage as the installed base of WAVE Systems has increased, resulting in increased consumable usage.

Sales in our Nucleic Acid operating segment continued to decreasedincreased in the firstsecond quarter of 2004 due to a decline inan increased demand for our specialty chemical building block products.phosphor amidates. These products are used by one of our biopharmaceutical and pharmaceuticalmajor customers as raw materials in DNA based drug candidates. The decrease in demand is largely attributable to the timing of completion and/or failure of Phase III clinical trials by certain of our large customers. We look forIncreased demand for these products to rebound slightly during the balance of 2004 as other customer products move through the clinical trial phases. This decrease in demand for DNA building blocks in the first quarter of 2004 was partially offset by sales of oligonucleotides generatedmanufactured by our start-up manufacturing facility in Boulder, Colorado.Colorado, resulted in additional sales increases. Part of our business strategy has been to position ourselves as a unique partner to biopharmaceutical and pharmaceutical companies in the early stages of their efforts to develop genomic-based diagnostics and therapeutics. As part of this strategy we are focusing our sales efforts on large consumers of our Synthetic Nucleic Acid products who are willing to commit to long-term supply agreements. While we expect to see increased sales of these products based upon this strategy, we also may see varying demand depending on the success of the biopharmaceutical and pharmaceutical companiescompany’s diagnostic and therapeutic products. As a result we may see large variations in revenue flows for these products.

Cost of Goods Sold. Cost of goods sold remained relatively flat year to year despite the declineincrease in our revenues. Fixed costs associated with excess manufacturing capacity in our Nucleic Acids business unit and a lower number of high margin Wave systemsWAVE Systems sold kept our cost of goods sold comparable to the firstsecond quarter of 2003. The BioSystems business unit cost of goods sold as a percentage of sales increased year over year but remained within historical ranges at approximately 44%. We expect that our BiosystemsBioSystems margins will fluctuate within historical ranges based upon the sales mix of systems, consumables and services. Currently our Nucleic Acid products are sold at lower margins compared to our BiosystemsBioSystems products. The margins in our Nucleic Acids business unit have been negatively impacted by higher manufacturing costs and excess capacity due largely to our plant expansion efforts in Glasgow, Scotland and Boulder, Colorado. We anticipate that our cost of goods sold for our Nucleic Acid products will remain under pressure due to continued excess capacity during 2004. Overall we anticipate that our cost of goods sold as a percentage of sales will be consistent with 2003 or slightly lower as we are hopeful that demand for our Nucleic Acid products will rebound slightly. Margin improvement will depend largely on the return of product demand thereby more fully utilizing our manufacturing capacity and spreading fixed costs across a larger revenue base.

Selling, General and Administrative Expenses. Selling, general and administrative expenses remained comparable to the second quarter of 2003. Reductions in personnel and personnel related expenses and travel costs decreased but were offset by foreign currency increases. We will remain focused on controlling and reducing expenses during 2004.

Research and Development Expenses. Research and development expenses decreased as a result of our restructuring activities and focus on expense control. Approximately 68% of the total decrease was in personnel and personnel related expenses as we have reduced our employee headcount. Additionally, reductions in outside services and supplies were realized. We will remain focused on controlling and reducing expenses during 2004.

Goodwill and Asset Impairment Charges:During the three months ended March 31, 2004, our Board of Directors directed us to explore strategic alternatives for the Nucleic Acids operating segment. The ongoing process has included significant due diligence by us, our advisors and prospective independent buyers and other interested parties.

Based upon information obtained through this process during the three months ended June 30, 2004, we determined that it was more likely than not that the assets of the Nucleic Acids business were impaired. Accordingly, we engaged an external valuation firm to assist with the completion of a mid-year impairment test. As a result, we recorded a non-cash charge of $11,964,387 related to its Nucleic Acids segment during the three months ended June 30, 2004. The charge consisted of $9,864,387 related to the impairment of goodwill and $2,100,000 related to the impairment of property and equipment.

Restructuring Charges. During the fourth quarter of 2002 management formulated and executed a significant portion of a restructuring plan. The plan was developed to reduce expenses thereby better aligning the Company’s expense structure with current business prospects. The plan included employee terminations, office closures, termination of collaborations and write-offs of abandoned intellectual property. We continued to execute the plan during the second quarter of 2003 resulting in the additional charges recorded in 2003. These charges consisted of mainly employee severance costs and office closings. We did not incur restructuring charges in the second quarter of 2004.

Income Taxes. The Company’s tax expense (benefit) relates to its operations in certain foreign countries and certain states. The tax benefit recorded in the second quarter of 2004 relates to payments in the United Kingdom. No further tax benefits are being recorded due to our cumulative losses, expected losses and the uncertainty as to whether we will be able to utilize any additional losses as carrybacks. We will continue to assess the recoverability of deferred tax assets and the related valuation allowance. We expect to continue to incur losses and expect to continue to provide valuation allowances against deferred tax assets. To the extent we begin to generate taxable income in future years and it is determined that such valuation allowance is no longer required; the tax benefit of the remaining deferred tax assets will be recognized. Our deferred tax assets as of June 30, 2004 were $38.0 million and were offset by a valuation allowance of $38.0 million.

Results of Operations Six Months Ending June 30, 2004 and 2003

Net Sales. Sales in our BioSystems operating segment decreased in 2004 compared to 2003. Bioinstruments revenues were significantly lower than 2003, but this decrease was partially offset by increased sales in our Discovery Services. The decline in systems sales is mainly due to weak demand from our North American customer base. Increased services revenue is attributable to our activities focused on providing genetic variation discovery and analysis services to a pharmaceutical base of customers. We believe that our genetic variation discovery and analysis services provide an ongoing revenue opportunity. A discovery service agreement with Novartis Pharmaceuticals Corp. supporting the clinical development of oncology therapeutics has provided a template to utilize for our services offering. Bioconsumable product sales strengthened as the installed base of WAVE Systems has increased, resulting in increased consumable usage.

Sales in our Nucleic Acid operating segment increased in the first six months of 2004 due to an increased demand for our specialty chemical phosphoramidates. These products are used by one of our major customers as raw materials in DNA-based drug candidates. Increased demand for oligonucleotides manufactured by our start-up manufacturing facility in Boulder, Colorado, resulted in additional sales increases. Part of our business strategy has been to position ourselves as a unique partner to biopharmaceutical and pharmaceutical companies in the early stages of their efforts to develop genomic-based diagnostics and therapeutics. As part of this strategy we are focusing our sales efforts on large consumers of our Synthetic Nucleic Acid products who are willing to commit to long-term supply agreements. While we expect to see increased sales of these products based upon this strategy, we also may see varying demand depending on the success of the biopharmaceutical and pharmaceutical company’s diagnostic and therapeutic products. As a result we may see large variations in revenue flows for these products.

Cost of Goods Sold. Cost of goods sold declined year to year consistent with the decline in our revenues. Fixed costs associated with excess manufacturing capacity in our Nucleic Acids business unit and a lower number of high margin WAVE Systems sold kept our cost of goods sold comparable to 2003. The BioSystems business unit cost of goods sold as a percentage of sales increased year over year but remained within historical ranges at approximately 44%. We expect that our BioSystems margins will fluctuate within historical ranges based upon the sales mix of systems, consumables and services. Currently, our Nucleic Acid products are sold at lower margins compared to our BioSystems products. The margins in our Nucleic Acids business unit have been negatively impacted by higher manufacturing costs and excess capacity due largely to our plant expansion efforts in Glasgow, Scotland and Boulder, Colorado. We anticipate that our cost of goods sold for our Nucleic Acid products will remain under pressure due to continued excess capacity during 2004. Overall, we anticipate that our cost of goods sold as a percentage of sales will be consistent with 2003 or slightly lower as we are hopeful that demand for our Nucleic Acid products will rebound slightly. Margin improvement will depend largely on the return of product demand thereby more fully utilizing our manufacturing capacity and spreading fixed costs across a larger revenue base.

Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased as a result of our focus on expense control. Reductions in personnel and personnel related expenses and travel costs attributed to the decrease, partially offset by foreign currency increases. We will remain focused on controlling and reducing expenses during 2004.

Research and Development Expenses. Research and development expenses decreased as a result of our restructuring activities and focus on expense control. Approximately 60%65% of the total decrease was in personnel and personnel related expenses as we have reduced our employee headcount. Additionally, reductions in outside services and supplies were realized. We will remain focused on controlling and reducing expenses during 2004. We expense

Goodwill and Asset Impairment Charges:During the three months ended March 31, 2004, our researchBoard of Directors directed us to explore strategic alternatives for the Nucleic Acids operating segment. The ongoing process has included significant due diligence by us, our advisors and development costs inprospective independent buyers and other interested parties.

Based upon information obtained through this process during the year in which they are incurred.three months ended June 30, 2004, we determined that it was more likely than not that the assets of the Nucleic Acids business were impaired. Accordingly, we engaged an external valuation firm to assist with the completion of a mid-year impairment test. As a result, we recorded a non-cash charge of $11,964,387 related to its Nucleic Acids segment during the three months ended June 30, 2004. The charge consisted of $9,864,387 related to the impairment of goodwill and $2,100,000 related to the impairment of property and equipment.

Restructuring Charges. During the fourth quarter of 2002 management formulated and executed a significant portion of a restructuring plan. The plan was developed to reduce expenses thereby better aligning the Company’s expense structure with current business prospects. The plan included employee terminations, office closures, termination of collaborations and write-offs of abandoned intellectual property. We continued to execute the plan during the first quarter of 2003 resulting in the additional charges recorded in 2003. These charges consisted of mainly employee severance costs and office closings. We didhave not incur furtherincurred any restructuring charges in the first quarter of 2004.

Income Taxes. The Company’s tax expense (benefit) relates to its operations in certain foreign countries and certain states. The tax benefit recorded in the first quarter of 2004 relates to refunds received in the United Kingdom. No further tax benefits are being recorded due to our cumulative losses, expected losses and the uncertainty as to whether we will be able to utilize any additional losses as carrybacks. We will continue to assess the recoverability of deferred tax assets and the related valuation allowance. We expect to continue to incur losses and expect to continue to provide valuation allowances against deferred tax assets. To the extent we begin to generate taxable income in future years and it is determined that such valuation allowance is no longer required, the tax benefit of the remaining deferred tax assets will be recognized. Our deferred tax assets as of March 31,June 30, 2004 were $32.1$38.0 million and were offset by a valuation allowance of $32.1$38.0 million.

Liquidity and Capital Resources

Overview

The Company’sOur liquidity position continued to be difficultand working capital positions deteriorated during the first quarter due predominantly to operating losses, particularly in our Nucleic Acids operating segment, increased investments in accounts receivable, short-term investments, inventory, and to a lesser extent, purchases of property and equipment. These operating losses and investments were funded primarily by our credit facility.

While we expect to meet our cash needs for the remainder of 2004, due primarilyit is essential that we eliminate or significantly reduce the operating losses in our Nucleic Acids operating segment. As previously mentioned, we are exploring strategic alternatives for this operating segment, which include but are not limited to, continued lossesthe sale of all or a portion of this business. To further enhance our liquidity and increases in working capital components. Weposition, we have beenor are developing i) processes to accelerate the collection of past-due (predominately international) receivables; ii) alternatives for reducing or delaying operating expenses and will continue to be focused on improving accounts receivables collectionscapital expenditures; and reducing inventory levels. iii) additional sources of capital.

As of March 31,June 30, 2004 and December 31, 2003, we had approximately $2.2 million$656,000 and $1.2 million, respectively, in cash and cash equivalents. In addition, as of March 31, 2004, we had $316,000$1.4 million in short-term investments as of June 30, 2004 and no short-term investments as of December 31, 2003, for total cash and short-term investments of approximately $2.5$2.1 million and $1.2 million, as of June 30, 2004 and December 31, 2003, respectively.

The following table summarizes our short-term liquidity and sources and uses of cash as of March 31,June 30, 2004 and December 31, 2003 and for the periods ended March 31,June 30, 2004 and 2003:

We expect to devote substantial capital resources to continue our research and development efforts, to support our marketing and sales and customer support activities, and for other general corporate activities. Our capital requirements for operations depend on a number of factors, including sales levels, the level of ourproduct and services, amounts paid for research and development activities, market acceptance of our products and services, the resources we devote to developing and supporting our products and services and general capital expenditures. The restructuring plan developed in 2002 has reduced our operating expenses and thereby reduced the cash needed to fund our operations. Additionally, our capital budget includes expenditures for the completion of our facility expansion projects in Glasgow, Scotland, and Boulder, Colorado, and for general facility and equipment improvements. Additional expansion projects for the Glasgow and Boulder production facilities may be incurred over the next 2 to 3 years as business demand dictates. We expect our capital expenditures to decrease significantly in 2004. Currently, we expect capital expenditures for 2004 to be in the range of $1.7 million to $2.5 million, depending largely upon demand for our nucleic acid products.

In December 2003, we entered into a three yearthree-year line of credit facility with Laurus. Under the terms of the agreement, we can borrow up to $7.5 million based on eligible accounts receivable and inventory balances. The agreement carries an interest rate of 2.0% over the prime rate or a minimum of 6.0%. Funds available under the line are determined by a borrowing base equal to 90% of eligible accounts receivable balances plus up to $1.0 million related to inventory balances. This line of credit is secured by most of our assets. Payment of interest and principal can, under certain circumstances, be made with shares of our common stock at a fixed conversion price of $2.20 per share. In January and February 2004, Laurus exercised its conversion rights on the line of credit and converted $2.0 million of amounts outstanding on the line into approximately 910,000 shares of common stock of the Company. As of March 31, 2004, we had approximately $4.4 million outstanding on this line of credit. In February 2004, Laurus waived the borrowing base limitation on our line through December 12,19, 2004, thereby making the full $7.5 million facility available to us regardless of the available collateral. As of August 13, 2004, we had approximately $2.3 million available under this facility.

In February 2004, we entered into a $2.75 million convertible note with Laurus, our line of credit provider. Management determined that the terms of the convertible note with Laurus were more favorable to the Company as compared to the previously announced proposed sale/leaseback transaction on our Glasgow, Scotland facility. The note carries an interest rate of prime plus 2% over the prime rate or a minimum of 6.0% and has a term of 3 years. The principal and interest on the note may be converted into common stock of the Company at a fixed conversion price of $2.61 per share. Proceeds from this transaction waswere used to retire the mortgage debt on the Glasgow facility, completefurther the build-out and consolidation of the Glasgow facility and provide funds for operations. Proceeds, net of transaction costs and amounts used to repay our existing mortgage debt on the Glasgow facility, were approximately $750,000.

As a result of our cost control measures and reduced capital expenditures, we expect our cash usage to decrease during 2004. Based upon our current projections, we expect to meet our cash needs for the remainder of 2004 from existing cash, additional cash generated from our working capital, and funds available to us under our $7.5 million credit facility. These projections assume revenue strengthfacility plus additional capital resulting from our Biosystems business unit. We believe growth will result from increased consumable product offerings and an increase in demand for our instruments. These projections also assume that revenues from our Nucleic Acid business unit increase in the future. Muchone or more of the anticipated increase instrategic alternatives related to the Nucleic Acid business unit revenues will come from new customers and additional business from existing customers of our Boulder, Colorado facility that began production in 2003. More specifically, our current financial and cash flow projections indicate that we expect to use approximately $1.5 million in cash to fund furtherAcids operating losses and an additional $1.3 million to $2.1 million for capital expenditures. The majority of the capital expenditures will be associated with our Nucleic Acids business unit.

These projections indicate a cash need of $2.6 million to $3.4 million for the remainder of 2004. Based upon the waiver received in February 2004, an additional $3.1 million is available when calculated as the total line of credit available of $7.5 million less $4.4 million outstanding at March 31, 2004.segment. These projections may or may not be realized based upon actual operating results and capital project requirements. Thus, during or after this period, if our existing cash balances, cash generated by our working capital, and available borrowings under credit agreements and other available capital are insufficient to satisfy our liquidity requirements, we may need to sell additional equity or debt securities, or obtain additional credit arrangements. We are monitoring our liquidity position and are prepared to take appropriate measures, as needed, to address liquidity. Such measures may include, but are not limited to, further expense reductions, an expansion of our line of credit, asset sales and the placement of equity or debt. We cannot assure you that any financing arrangement will be available in amounts or on terms acceptable to us. Our failure to raise additional capital, if needed, would harm our financial condition, results of operations and our business.

Analysis of Cash Flows

DuringCash flows used in operating activities totaled $7.3 million during the first quarter ofsix months ended June 30, 2004 our major cash expenditures were the funding of our operations and capital projects. Cash and investments increased by a total of approximately $1.0 million in 2004 as compared to $6.7 million during the comparable period of 2003. The use during 2004 is largely attributable to operating losses particularly in our Nucleic Acids business segment and a decrease of approximately $3.3 millionnet investment in 2003. Inworking capital.

Cash flows from investing activities totaled $106,000 during the six months ended June 30, 2004 approximately $4.0 million was usedcompared to fund our operations and $600,000cash flows used in investing activities of $1.1 million during the comparable period of 2003. The investing cash flows generated in 2004 were from the sale of short-term investments and reductions in other assets that were offset by $3.4 million provided by advances on our linepurchases of credit and $1.0 million of additional long-term debt.

Our operating activities resulted in net outflows of approximately $4.0 million and $3.1 million in 2004 and 2003, respectively. The operating cash outflows for these periods resulted mainly from our operating losses. Significant manufacturing operations overcapacity, and significant investment in research and development and sales and marketing contributed to the operating losses.

Net cash utilized for investing activities was approximately $600,000 in 2004 compared to net cash provided by investing activities of $200,000 for 2003. The cash out flow for investing activities in 2004 is due primarily to the investment in property plant and equipment.

Net cash provided byCash flows from financing activities was approximately $4.4totaled $6.7 million during the six months ended June 30, 2004 compared to $1.4 million during the comparable period of 2003. The cash from financing activities in 2004 and zero for 2003. The financing cash inflows in 2004 were the result of advancesrelate primarily to draws on our line ofLaurus credit facility and additional long-term debt increase.proceeds from the separate convertible note with Laurus.

Obligations and Commitments

Our ongoing capital commitments consist of debt service requirements and obligations under capital leases. The following table sets forth our contractual obligations along with cash payments due in each period indicated: