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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(MARK ONE)
[x] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
[ ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
COMMISSION FILE NUMBER: 000-30369
VIROLOGIC, INC.
DELAWARE (STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION) | 94-3234479 (IRS EMPLOYER IDENTIFICATION NO.) |
345 OYSTER POINT BLVD
SOUTH SAN FRANCISCO, CA 94080
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
TELEPHONE NUMBER (650) 635-1100
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ ] No [x]
As of May 3, 2004 there were 53,428,039 shares of the registrant’s common stock outstanding.
VIROLOGIC, INC.
INDEX
PAGE | ||||||||
NO. | ||||||||
PART I. FINANCIAL INFORMATION | ||||||||
Item 1. Financial Statements | ||||||||
3 | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
10 | ||||||||
27 | ||||||||
28 | ||||||||
28 | ||||||||
28 | ||||||||
28 | ||||||||
28 | ||||||||
29 | ||||||||
29 | ||||||||
30 | ||||||||
EXHIBIT 10.1 | ||||||||
EXHIBIT 31.1 | ||||||||
EXHIBIT 31.2 | ||||||||
EXHIBIT 32.1 |
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VIROLOGIC, INC.
(In thousands, except share data)
March 31, | December 31, | |||||||
2004 | 2003 | |||||||
(Unaudited) | (Note 1) | |||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 9,233 | $ | 8,893 | ||||
Short-term investments | 251 | 537 | ||||||
Accounts receivable, net of allowance for doubtful accounts of $653 and $643 at March 31, 2004 and December 31, 2003, respectively | 6,581 | 6,165 | ||||||
Prepaid expenses | 549 | 700 | ||||||
Inventory | 1,259 | 1,378 | ||||||
Restricted cash | 426 | 426 | ||||||
Other current assets | 151 | 267 | ||||||
Total current assets | 18,450 | 18,366 | ||||||
Property and equipment, net | 7,790 | 8,445 | ||||||
Restricted cash | 350 | 350 | ||||||
Other assets | 1,341 | 1,217 | ||||||
Total assets | $ | 27,931 | $ | 28,378 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 1,816 | $ | 1,556 | ||||
Accrued compensation | 1,287 | 862 | ||||||
Accrued lease termination | 189 | — | ||||||
Accrued liabilities | 1,658 | 2,108 | ||||||
Deferred revenue | 652 | 268 | ||||||
Current portion of capital lease obligations | 265 | 401 | ||||||
Current portion of loans payable | 54 | 133 | ||||||
Total current liabilities | 5,921 | 5,328 | ||||||
Long-term portion of capital lease obligations | 62 | 87 | ||||||
Other long-term liabilities | 385 | 382 | ||||||
Redeemable convertible preferred stock, $0.001 par value, 274 shares authorized, designated by series, issued and outstanding at March 31, 2004 and December 31, 2003; aggregate liquidation preference of $2,769 at March 31, 2004 | 1,994 | 1,994 | ||||||
Commitments | ||||||||
Stockholders’ equity: | ||||||||
Preferred stock, $0.001 par value, 4,999,726 shares authorized, designated by series, none issued and outstanding at March 31, 2004 and December 31, 2003 | — | — | ||||||
Common stock, $0.001 par value, 100,000,000 shares authorized; 53,425,292 and 52,608,382 shares issued and outstanding at March 31, 2004 and December 31, 2003, respectively | 53 | 53 | ||||||
Additional paid-in capital | 127,035 | 126,805 | ||||||
Accumulated other comprehensive income | 1 | 1 | ||||||
Accumulated deficit | (107,520 | ) | (106,272 | ) | ||||
Total stockholders’ equity | 19,569 | 20,587 | ||||||
Total liabilities and stockholders’ equity | $ | 27,931 | $ | 28,378 | ||||
See accompanying notes to Condensed Financial Statements.
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VIROLOGIC, INC.
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended | ||||||||
March 31, | ||||||||
2004 | 2003 | |||||||
Revenue: | ||||||||
Product revenue | $ | 8,640 | $ | 6,551 | ||||
Contract revenue | 382 | 417 | ||||||
Total revenue | 9,022 | 6,968 | ||||||
Operating costs and expenses: | ||||||||
Cost of product revenue | 4,416 | 3,819 | ||||||
Research and development | 1,393 | 1,346 | ||||||
Sales and marketing | 1,958 | 1,842 | ||||||
General and administrative | 2,080 | 2,466 | ||||||
Lease termination charge | 433 | — | ||||||
Total costs and expenses | 10,280 | 9,473 | ||||||
Operating loss | (1,258 | ) | (2,505 | ) | ||||
Interest income | 21 | 37 | ||||||
Interest expense | (11 | ) | (52 | ) | ||||
Other income | — | 52 | ||||||
Net loss | (1,248 | ) | (2,468 | ) | ||||
Deemed dividend to preferred stockholders | — | (2,155 | ) | |||||
Preferred stock dividend | (68 | ) | (467 | ) | ||||
Loss applicable to common stockholders | $ | (1,316 | ) | $ | (5,090 | ) | ||
Basic and diluted loss per common share | $ | (0.02 | ) | $ | (0.18 | ) | ||
Weighted-average shares used in computing basic and diluted loss per common share | 53,137 | 28,353 | ||||||
See accompanying notes to Condensed Financial Statements.
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VIROLOGIC, INC.
(In thousands)
(Unaudited)
Three Months Ended | ||||||||
March 31, | ||||||||
2004 | 2003 | |||||||
OPERATING ACTIVITIES | ||||||||
Net loss | $ | (1,248 | ) | $ | (2,468 | ) | ||
Adjustments to reconcile net loss to net cash provided by (used in) operating activities: | ||||||||
Depreciation and amortization | 720 | 923 | ||||||
Loss on disposal of fixed assets related to lease termination | 108 | — | ||||||
Stock-based compensation | 12 | 79 | ||||||
Amortization of deferred gain on lease assignment | — | (52 | ) | |||||
Changes in assets and liabilities: | ||||||||
Accounts receivable | (416 | ) | 525 | |||||
Prepaid expenses | 151 | 298 | ||||||
Inventory | 119 | 121 | ||||||
Other current assets | 116 | (1 | ) | |||||
Accounts payable | 260 | 401 | ||||||
Accrued compensation | 425 | 296 | ||||||
Accrued lease termination | 189 | — | ||||||
Accrued liabilities | (381 | ) | (833 | ) | ||||
Deferred revenue | 384 | 32 | ||||||
Long-term deferred rent | 3 | (11 | ) | |||||
Net cash provided by (used in) operating activities | 442 | (690 | ) | |||||
INVESTING ACTIVITIES | ||||||||
Purchases of short-term investments | — | (1,032 | ) | |||||
Maturities and sales of short-term investments | 286 | 1,030 | ||||||
Capital expenditures | (173 | ) | (133 | ) | ||||
Other assets | (124 | ) | (122 | ) | ||||
Net cash used in investing activities | (11 | ) | (257 | ) | ||||
FINANCING ACTIVITIES | ||||||||
Principal payments on loans payable | (79 | ) | (211 | ) | ||||
Payments on capital lease obligations | (161 | ) | (284 | ) | ||||
Net proceeds from issuance of common stock | 149 | 1 | ||||||
Expenses relating to issuance of preferred stock | — | (71 | ) | |||||
Net cash used in financing activities | (91 | ) | (565 | ) | ||||
Net increase (decrease) in cash and cash equivalents | 340 | (1,512 | ) | |||||
Cash and cash equivalents at beginning of period | 8,893 | 10,559 | ||||||
Cash and cash equivalents at end of period | $ | 9,233 | $ | 9,047 | ||||
See accompanying notes to Condensed Financial Statements.
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VIROLOGIC, INC.
March 31, 2004
(Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting only of adjustments of a normal recurring nature) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004 or any other future periods. The condensed balance sheet as of December 31, 2003 has been derived from the audited financial statements as of that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the audited financial statements and notes thereto included in our Annual Report to Stockholders on Form 10-K for the year ended December 31, 2003.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Revenue Recognition
Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, such as Medicare and Medicaid. Billings for services under third-party payor programs are included in revenue net of allowances for differences between the amounts billed and estimated receipts under such programs. The Company estimates these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies, an adjustment to the allowance may be necessary. Revenue generated from the Company’s database of resistance test results is recognized when earned under the terms of the related agreements, generally upon shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health (“NIH”) grants and commercial assay development, and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. Deferred revenue relates to cash received in advance of meeting the revenue recognition criteria described above.
Accounts Receivable
The process for estimating the ultimate collection of receivables involves significant assumptions and judgments. Billings for services under third-party payor programs are recorded as revenue net of allowances for differences between amounts billed and the estimated receipts under such programs. Adjustments to the estimated receipts, based on final settlement with the third-party payors, are recorded upon settlement as an adjustment to net revenue. In addition, the Company reviews and estimates the collectibility of receivables based on the period of time they have been outstanding. Historical collection and payor reimbursement experience is an integral part of the estimation process related to the allowance for doubtful accounts. Revisions to the allowance for doubtful accounts estimate are included in general and administrative expenses.
Inventory
Inventory is stated at the lower of standard cost, which approximates actual cost on a first-in, first-out basis, or market. If inventory costs exceed expected market value due to obsolescence or lack of demand, reserves are recorded for the difference between the cost and the market value. These reserves are based on estimates. Inventory consists of the following:
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MARCH 31, | DECEMBER 31, | |||||||
2004 | 2003 | |||||||
Raw materials | $ | 771 | $ | 832 | ||||
Work in process | 488 | 546 | ||||||
Total | $ | 1,259 | $ | 1,378 | ||||
Stock-Based Compensation
The Company has elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation” (“APB 25”) to account for employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards Board Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123” (“SFAS 148”) requires the disclosure of pro forma information regarding net loss and net loss per share as if the Company had accounted for its stock options under the fair value method.
The information regarding loss applicable to common stockholders and loss per share prepared in accordance with SFAS 123 has been determined as if the Company had accounted for its employee stock option and employee stock purchase plans using the fair value method prescribed by SFAS 123. The resulting pro forma effects on loss applicable to common stockholders and loss per share pursuant to SFAS 123 as amended by SFAS 148 are not likely to be representative of the effects in future years, due to the vesting provisions of employee stock options and the inclusion of additional grants in subsequent years.
At March 31, 2004, the Company had two stock-based employee compensation plans: the 2000 Equity Incentive Plan and the 2000 Employee Stock Purchase Plan. The Company estimates the fair value of these stock options and stock purchase rights at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions for the three months ended March 31, 2004 and 2003: risk-free interest rate of 2.8% and 2.9% in 2004 and 2003, respectively; a weighted-average expected life of stock options from grant date of four years; a weighted-average expected stock purchase right of six months; volatility factor of the expected market price of the Company’s common stock of 100%; and a dividend yield of zero.
For purposes of disclosures pursuant to SFAS 123 as amended by SFAS 148, the estimated fair value of the stock options and stock purchase rights are amortized to expense over the vesting period. The Company’s pro forma information is as follows:
Three Months Ended | ||||||||
March 31, | ||||||||
2004 | 2003 | |||||||
(In thousands, except per | ||||||||
share amounts) | ||||||||
Loss applicable to common stockholders — as reported | $ | (1,316 | ) | $ | (5,090 | ) | ||
Add back: | ||||||||
Amortization of deferred compensation | — | 77 | ||||||
Deduct: | ||||||||
Stock-based compensation expense for employee awards determined under SFAS 123 | (529 | ) | (504 | ) | ||||
Pro forma loss applicable to common stockholders | $ | (1,845 | ) | $ | (5,517 | ) | ||
Loss per common share: | ||||||||
Loss applicable to common stockholders — as reported | $ | (0.02 | ) | $ | (0.18 | ) | ||
Loss applicable to common stockholders — pro forma | $ | (0.03 | ) | $ | (0.19 | ) | ||
The Company accounts for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued and expensed over their vesting periods, which approximates the period over which services are rendered or goods are received.
2. COMPREHENSIVE INCOME (LOSS)
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Comprehensive income (loss) is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) includes certain changes in equity that are excluded from net income (loss). Specifically, unrealized gains and losses on our available-for-sale securities, which are reported separately in stockholders’ equity, are included in accumulated other comprehensive income. Net loss approximates comprehensive loss for the three months ended March 31, 2004 and 2003.
3. LOSS PER SHARE
Basic loss per common share is calculated based on the weighted-average number of common shares outstanding during the periods presented. Diluted earnings per common share would give effect to the dilutive impact of potential common shares which consists of convertible preferred stock (using the as-if converted method), and stock options and warrants (using the treasury stock method). Potentially dilutive securities have been excluded from the diluted loss per common share computations in all periods presented as such securities have an anti-dilutive effect on loss per common share due to the Company’s net loss.
4. CAPITAL STOCK
Preferred Stock
Series A Redeemable Convertible Preferred Stock
In 2001, the Company issued and sold, in a private placement, an aggregate of 1,625 shares of the Company’s Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”) and warrants to purchase an aggregate of 3.2 million shares of common stock, for an aggregate purchase price of $16.25 million.
Of the 1,625 shares issued in the financing, 274 shares remain outstanding as of March 31, 2004, and the remainder was converted into an aggregate of approximately 7.4 million shares of the Company’s common stock. As a result of the Company’s sale of Series C Preferred Stock, the conversion price of the Series A Preferred Stock and the exercise price of the warrants issued to the purchasers of the Series A Preferred Stock has each been reduced to $1.11. Accordingly, the 274 shares of Series A Preferred Stock outstanding are convertible into approximately 2.5 million shares of common stock, and the outstanding warrants are exercisable for approximately 4.0 million shares of common stock.
The Series A Preferred Stock bears dividends payable in common stock semi-annually. The dividends were initially at an annual rate of 6% but increased to an 8% annual rate on the fourth such payment, which was made in 2003, and will increase by 2 percentage points every six months up to a maximum annual rate of 14%. Subject to the limitations described below, the holders of Series A Preferred Stock may elect to convert their shares into the Company’s common stock at any time, just as they may choose to exercise their warrants at any time. Also subject to the limitations described below, the Company may, at its option, convert the Series A Preferred Stock into common stock at any time after June 21, 2002 for Series A Preferred Stock issued at the first closing and after July 9, 2002 for Series A Preferred Stock issued at the second closing, but only if the Company’s stock price exceeds $5.10 for 20 consecutive trading days. The Company may also, at its option, convert the Series A Preferred Stock into common stock upon a sale of common stock in a firm commitment underwritten offering to the public if the public offering price exceeds $5.10, the aggregate gross proceeds exceed $40 million and the registration statements covering shares underlying the Series A Preferred Stock are effective.
The holders are not subject to any limitations on the number of conversions of Series A Preferred Stock or subsequent sales of the corresponding common stock, that they can effect, other than a prohibition on any holder acquiring beneficial ownership of more than 4.99% of the outstanding shares of the Company’s common stock. This limitation also applies to the Company’s ability to convert Series A Preferred Stock.
The holders of Series A Preferred Stock have the right to require the Company to redeem all of the Series A Preferred Stock for cash equal to the greater of (i) 115% of their original purchase price plus 115% of any accrued and unpaid dividend or (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. Series A Preferred Stock is redeemable by the holders in any of the following situations:
• | If the Company fails to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrant and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws |
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• | If the Company fails to have sufficient shares of common stock reserved to satisfy conversions of the series | |||
• | If the Company fails to honor requests for conversion, or if the Company notifies any holder of such series of its intention not to honor future requests for conversion | |||
• | If the Company institutes voluntary bankruptcy or similar proceedings | |||
• | If the Company makes an assignment for the benefit of creditors, or applies for or consents to the appointment of a receiver or trustee for the Company or for a substantial part of the Company’s property or business, or such a receiver or trustee shall otherwise be appointed | |||
• | If the Company sells all or substantially all of its assets | |||
• | If the Company merges, consolidates or engages in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K | |||
• | If the Company commits a material breach under, or otherwise materially violates the terms of, the transaction documents entered into in connection with the issuance of such series | |||
• | If the registration statements covering shares of common stock underlying the Series A Preferred Stock and related warrants cannot be used by the respective selling security holders for the resale of all the underlying shares of common stock for an aggregate of more than 30 days | |||
• | If the Company’s common stock is not tradable on the NYSE, the AMEX, the Nasdaq National Market or the Nasdaq SmallCap market for an aggregate of twenty trading days in any nine month period | |||
• | If 35% or more of the Company’s voting power is held by any one person, entity or group | |||
• | If the Company fails to pay any indebtedness in excess of $350,000 when due, or if there is any event of default under any agreement that is likely to have a material adverse effect on the Company | |||
• | Upon the institution of involuntary bankruptcy proceedings |
Upon the occurrence of any of the redemption events described above, individual holders of the Series A Preferred Stock would have the option, while such event continues, to require the Company to purchase some or all of the then outstanding shares of Series A Preferred Stock held by such holder. If the Company receives any notice of redemption, the Company is required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when the Company received the redemption notice and the amount of preferred stock covered by the notice. If holders of the Series A Preferred Stock were to exercise their rights to redeem a material number of their shares as a result of any of the events described above, such a redemption could have a material adverse effect on the Company.
Subject to certain conditions, the Company may redeem the Series A Preferred Stock at any time. Due to the nature of the redemption features of the Series A Preferred Stock, such stock has been excluded from permanent equity in the Company’s financial statements.
The Company initially recorded the Series A Preferred Stock at its fair value on the date of issuance. In accordance with EITF Topic D-98: Classification and Measurement of Redeemable Securities (“EITF Topic D-98”), the Company has elected not to adjust the carrying value of the Series A Preferred Stock to the redemption value of such shares, since it is uncertain whether or when the redemption events described above will occur. Subsequent adjustments to increase the carrying value to the redemption value will be made when it becomes probable that such redemption will occur. As of March 31, 2004, the redemption value of the Series A Preferred Stock was $3.2 million.
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Liquidation Preference
The holders of the Series A Preferred Stock are entitled to receive, upon liquidation of the Company, an amount equal to $10,000 per share of Series A Preferred Stock plus all accrued and unpaid premiums thereon. Any assets remaining for distribution following the payment of the preferences to the holders of the Series A Preferred Stock shall be distributed to the holders of the common stock. As of March 31, 2004, the liquidation preference of the Series A Preferred Stock was $2.8 million.
5. COMMITMENTS
At March 31, 2004, the Company leased one building which covers 41,000 square feet in South San Francisco, California. The lease expires in April 2010 and provides an option to extend the term for an additional ten years. In addition, at March 31, 2004, the Company subleased approximately 14,000 square feet in South San Francisco, California. This sublease expires on December 31, 2004.
In March 2004, the Company terminated a lease for its original laboratory and office space of approximately 25,000 square feet in South San Francisco, California. Under the terms of the lease termination agreement, the Company recorded a charge of $433,000 primarily related to the termination payment and the write-off of the net carrying value of the related leasehold improvements. This early termination enabled the Company to eliminate operating expenses related to this lease going forward and reduce its aggregate remaining obligation by approximately half.
In June 2002, the Company assigned a lease of excess laboratory and office space and transferred ownership through the sale of related leasehold improvements and equipment to a third party. The Company received net proceeds from the lease assignment of $3.8 million, resulting in a net gain of $0.3 million which was recognized as other income over the initial sublease term. In the event of default by the assignee, the Company would be contractually obligated for payments under the lease of: $0.8 million in 2004; $1.4 million in 2005; $1.5 million in 2006; $1.5 million in 2007; $1.5 million in 2008; and $3.9 million from 2009 to 2011.
At March 31, 2004, contractual obligations for the next five years and thereafter, excluding the lease assignment guarantee discussed above, are as follows:
Payments Due By Period | ||||||||||||||||||||
Less Than | ||||||||||||||||||||
1 Year | 2-3 Years | 4-5 Years | Thereafter | Total | ||||||||||||||||
(In thousands) | ||||||||||||||||||||
Operating leases | $ | 1,222 | $ | 1,950 | $ | 2,066 | $ | 1,153 | $ | 6,391 | ||||||||||
Capital leases | 265 | 42 | 20 | — | 327 | |||||||||||||||
Loans | 54 | — | — | — | 54 | |||||||||||||||
Total | $ | 1,541 | $ | 1,992 | $ | 2,086 | $ | 1,153 | $ | 6,772 | ||||||||||
In addition, the Company is obligated to pay dividends to the Series A preferred stockholders. See “Capital Stock” note for further discussion.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results Of Operations
The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto included in this Form 10-Q.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 including, without limitation, statements regarding our PhenoSense and GeneSeq testing products, the growth of our pharmaceutical business, research and development expenditures, adequacy of our capital resources, and other financial matters. These statements, which sometimes include words such as “expect,” “goal,” “may,” “anticipate,” “should,” “continue,” or “will,” reflect our expectations and assumptions as of the date of this Quarterly Report based on currently available operating, financial and competitive information. Actual results could differ materially from those in the forward-looking statements as a result of a number of factors, including our ability to raise additional capital, the market acceptance of our resistance testing products, the effectiveness of our competitors’ existing products and new products, the ability to effectively manage
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growth and the risks associated with our dependence on patents and proprietary rights. These factors and others are more fully described in “Risk Factors Related to Our Business” and elsewhere in this Form 10-Q. We assume no obligation to update any forward-looking statements.
OVERVIEW
We are a biotechnology company developing, marketing and selling innovative products to guide and improve treatment of viral diseases. We incorporated in the state of Delaware on November 14, 1995 and commenced commercial operations in 1999. We developed a practical way of directly measuring the impact of genetic mutations on drug resistance and using this information to guide therapy. We have proprietary technology, called PhenoSense, for testing drug resistance in viruses that cause serious viral diseases such as HIV/AIDS and hepatitis. Our products are used by physicians in selecting optimal treatments for their HIV patients and by industry, academia and government for clinical studies, drug screening and characterization, and basic research.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. See Note 1 to the financial statements for further discussion. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our financial statements:
Revenue Recognition
Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, such as Medicare and Medicaid. Billings for services under third-party payor programs are included in revenue net of allowances for differences between the amounts billed and estimated receipts under such programs. We estimate these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies, an adjustment to the allowance may be necessary. Revenue generated from our database of resistance test results is recognized when earned under the terms of the related agreements, generally upon shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health (“NIH”) grants and commercial assay development, and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. Deferred revenue relates to cash received in advance of meeting the revenue recognition criteria described above.
Accounts Receivable
The process for estimating the ultimate collection of receivables involves significant assumptions and judgments. Billings for services under third-party payor programs are recorded as revenue net of allowances for differences between amounts billed and the estimated receipts under such programs. Adjustments to the estimated receipts, based on final settlement with the third-party payors, are recorded upon settlement as an adjustment to net revenue.
In addition, we review and estimate the collectibility of our receivables based on the period of time they have been outstanding. Historical collection and payor reimbursement experience is an integral part of the estimation process related to reserves for doubtful accounts. In addition, we assess the current state of our billing functions in order to identify any known collection or reimbursement issues in order to assess the impact, if any, on our reserve estimates, which involves judgment. We believe that the collectibility of our receivables is directly linked to the quality of our billing processes, most notably those related to obtaining the correct information in order to bill effectively for the services we provide. As such, we have implemented procedures to reduce the number of requisitions that we receive from healthcare providers with missing or incorrect billing information. Revisions in reserve for doubtful accounts estimates are recorded as an adjustment to bad debt expense within general and administrative expenses. We believe that our collection and reserves processes, along with our close monitoring of our billing processes, helps to reduce the risk associated with material revisions to reserve estimates resulting from adverse changes in collection and reimbursement experience and billing operations.
Deferred Tax Assets
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We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. Due to our lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance.
Deemed Dividends
We estimated a beneficial conversion feature for our convertible preferred stock in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments” based on the difference between the estimated conversion price and common stock fair market value at the date of issuance. We use the Black-Scholes option valuation model to estimate the conversion price at the date of issuance. This model considers a number of factors requiring judgment including the weighted-average expected life of stock options from grant date and the volatility factor of the expected market price of the Company’s common stock. We recorded the beneficial conversion feature as a deemed dividend on the Statement of Operations, resulting in an increase to the net loss applicable to common stockholders in the calculation of basic and diluted net loss per common share.
Stock-Based Compensation
We have elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation” (“APB 25”) to account for employee stock options. Under APB 25, no compensation expense is recognized because the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards Board Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123” (“SFAS 148”) requires the disclosure of pro forma information regarding net loss and net loss per share as if we had accounted for stock options under the fair value method. See “Summary of Significant Accounting Policies” note to the financial statements for further discussion.
We account for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued and expensed over their vesting periods. We estimate the fair value of these stock options and stock purchase rights at the date of grant using the Black-Scholes option valuation model, which considers a number of factors requiring judgment.
RESULTS OF OPERATIONS
Three Months Ended March 31, 2004 and 2003
Three Months Ended | ||||||||
March 31, | ||||||||
2004 | 2003 | |||||||
(In thousands) | ||||||||
Patient testing | $ | 5,774 | $ | 5,294 | ||||
Pharmaceutical company testing | 2,866 | 1,257 | ||||||
Product revenue | 8,640 | 6,551 | ||||||
Contract revenue | 382 | 417 | ||||||
Total revenue | $ | 9,022 | $ | 6,968 | ||||
Revenue. Revenue increased to $9.0 million in the first quarter of 2004 from $7.0 million in the corresponding quarter of 2003, an increase of 29%. The increase was primarily attributable to growth in the HIV resistance testing market and increased demand for our PhenoSense HIV, PhenoSense GT and GeneSeq HIV products for patient and pharmaceutical testing. Contract revenue consists of revenue from NIH research grants and commercial assay development, and other non-product revenue. In 2003, we were awarded four Small Business Innovation Research (“SBIR”) grants from the National Institute of Allergy and Infectious Diseases (“NIAID”), a division of the U.S. National Institutes of Health, totaling more than $4 million over three years. These grants will help support the development of analytical and database tools to facilitate the identification and characterization of drug resistant strains of HIV, and assays that will aid in the pre-clinical and clinical evaluation of the next generation of anti-viral therapeutics. We believe increased demand for existing and new products will be the primary factors contributing to an increased level of sales in 2004 as compared to
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2003. We anticipate quarterly differences in the revenue growth rate due to timing of various clinical studies for pharmaceutical customers and the seasonal effects observed in patient testing, which have historically occurred in the first quarter.
Cost of product revenue. Cost of product revenue increased to $4.4 million in the first quarter of 2004 from $3.8 million in the corresponding quarter of 2003. The increase was primarily due to the higher volume of testing. Included in these costs are materials, supplies, labor and overhead related to product revenue. Gross margin on product revenue increased to 49% in the first quarter of 2004 from 42% in the corresponding quarter of 2003 primarily due to improved efficiencies in laboratory operations as well as increased contribution from pharmaceutical revenue during the quarter. We anticipate that gross margin on our product revenue will continue to improve as revenue increases and further operational efficiencies and economies of scale are achieved.
Research and development. Research and development expenses increased to $1.4 million in the first quarter of 2004 from $1.3 million in the corresponding quarter of 2003. Total research and development expenses included costs associated with contract revenue as follows:
Three Months Ended | ||||||||
March 31, | ||||||||
2004 | 2003 | |||||||
(In thousands) | ||||||||
NIH Grants: | ||||||||
HIV assays | $ | 278 | ||||||
HIV Database | 38 | |||||||
HCV assay | 66 | |||||||
Commercial assay development and other projects | — | $ | 190 | |||||
Total | $ | 382 | $ | 190 | ||||
Because our resistance tests target viral diseases and our product lines overlap, most of our core research and development activities are advancing multiple potential product lines. Due to this substantial overlap, we do not track costs on a project by project basis, except for the costs reimbursed by the NIH as discussed above. We expect research and development spending in the future to trend with the level of NIH grants and/or other research and development cost reimbursement arrangements under contract.
Below is a summary of products and products in development. The information in the column labeled “Estimated Completion” contains forward-looking statements regarding completion of products in development and is dependent on securing NIH grants and/or other research and development funding as well as demand for the products. The actual timing of completion of those products could differ materially from the estimates provided in the table.
The following summarizes our products and products in development:
Estimated | ||||
Completion | ||||
PhenoSense HIV, a phenotypic HIV test | ||||
Pharmaceutical and patient testing | Completed | |||
GeneSeq HIV, a genotypic HIV test | ||||
Pharmaceutical and patient testing | Completed | |||
PhenoSense GT, a combination phenotype/genotype HIV test | ||||
Pharmaceutical and patient testing | Completed | |||
Replication Capacity HIV, a measurement of fitness(1) | ||||
Pharmaceutical and patient testing | Completed | |||
PhenoScreen, a high-throughput screening assay | ||||
Pharmaceutical testing | Completed | |||
PhenoSense HIV Antibody Neutralization for Vaccine Development | ||||
Pharmaceutical testing | Completed | |||
PhenoSense HIV Entry and GeneSeq HIV Entry, entry inhibitor assays(2) | ||||
Pharmaceutical testing | Completed | |||
Patient testing(6) | 2004 | |||
PhenoSense HIV Co-Receptor Tropism, an entry assay | ||||
Pharmaceutical testing | Completed | |||
Patient testing(4) | 2004 | |||
PhenoSense and GeneSeq HIV Integrase assays | ||||
Pharmaceutical testing | 2004 |
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Estimated | ||||
Completion | ||||
Patient testing(3) | 2006 | |||
GeneSeq HCV, a genotypic hepatitis C test | ||||
Pharmaceutical testing | Completed | |||
Patient testing(3) | 2005 | |||
PhenoSense HCV, a phenotypic hepatitis C test | ||||
Pharmaceutical testing | 2005 | |||
Patient testing(3) | 2006 | |||
GeneSeq HBV, a genotypic hepatitis B test | ||||
Pharmaceutical testing | Completed | |||
Patient testing | (5 | ) | ||
PhenoSense HBV, a phenotypic hepatitis B test | ||||
Pharmaceutical testing | (5 | ) | ||
Patient testing | (5 | ) |
(1) | Currently offered free of charge on phenotypic reports, in the future may be offered as a stand-alone product. | |
(2) | This test may be incorporated into one of our existing products or possibly offered as a stand-alone product. | |
(3) | This test is expected to be offered after more pharmaceutical drugs are available for patient use and based on demand for the product. | |
(4) | This test was validated in 2004 for use in clinical trials, and is expected to be subsequently offered to patients based on demand for the product. | |
(5) | The timing of estimated completion is under evaluation and is dependant on securing NIH grants and/or other research and development funding as well as demand for the product. | |
(6) | The phenotypic test for the FDA approved fusion inhibitor drug, Fuzeon, is expected to be validated in 2004 and available for patient use dependent on demand for the product. |
Sales and marketing. Sales and marketing expenses increased to $2.0 million in the first quarter of 2004 from $1.8 million in the corresponding quarter of 2003. This increase was primarily attributable to the expansion of our sales force and increased marketing programs related to our existing products. We expect sales and marketing expenses in 2004 to increase from 2003 levels but at a lower growth rate than the projected revenue growth rate primarily due to continued effective utilization of our sales and marketing capabilities.
General and administrative. General and administrative expenses decreased to $2.1 million in the first quarter of 2004 from $2.5 million in the corresponding quarter of 2003. The decrease was primarily due to a decrease in fees for professional services and lower non-cash compensation expenses related to the granting of stock and stock options prior to our initial public offering. We expect general and administrative expenses in 2004 to increase from 2003 levels but at a lower growth rate than the projected revenue growth rate primarily due to continued leveraging of existing infrastructure.
Lease termination charge. On March 22, 2004, we terminated a lease for our original laboratory and office space of approximately 25,000 square feet in South San Francisco, California. Under the terms of the lease termination agreement, we recorded a charge of $433,000 primarily related to the termination payment and the write-off of the net carrying value of the related leasehold improvement. This early termination enabled us to eliminate operating expenses related to this lease going forward and reduce our aggregate remaining obligation by approximately half.
Interest income. Interest income decreased to $21,000 in the first quarter of 2004 from $37,000 in the corresponding quarter of 2003. This decrease was primarily due to lower interest rates.
Interest expense. Interest expense decreased to $11,000 in the first quarter of 2004 from $52,000 in the corresponding quarter of 2003. This decrease was primarily due to the payoff of several equipment loans which ended.
Other income.Other income of $52,000 in the first quarter of 2003 represents residual income from our lease assignment in 2002.
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Deemed dividend.On February 4, 2003, our stockholders approved the conversion of certain convertible secured promissory notes (“Notes”) issued to prior Series B preferred stockholders into Series C Preferred Stock and the issuance of warrants to purchase shares of our common stock in exchange for warrants originally issued in connection with Series B Preferred Stock. The warrant exchange resulted in a charge of $2.2 million which was recorded at the time of the exchange in the first quarter of 2003.
The beneficial conversion feature was calculated in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and Emerging Issues Task Force Consensus No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” The beneficial conversion feature was reflected as deemed dividends in the Statement of Operations of $2.2 million in the first quarter of 2003, and was included in stockholders’ equity as offsetting charges and credits to additional paid-in capital.
Preferred stock dividend.We recorded a preferred stock dividend of $0.1 million and $0.5 million in the first quarter of 2004 and 2003, respectively. The Series A Preferred Stock issued in 2001 bears an initial 6% annual dividend rate, payable twice a year in shares of common stock, which increases to an 8% annual rate on the fourth such payment, and then increases by 2 percentage points every six months thereafter up to a maximum annual rate of 14%. The Series C Preferred Stock bore an initial 8% annual dividend rate, payable quarterly, which increases to a 9% annual dividend rate on June 30, 2004, and by one percentage point every quarter thereafter up to a maximum annual rate of 14%. In December 2003, we elected to convert all Series C Convertible Preferred Stock then outstanding into common stock.
LIQUIDITY AND CAPITAL RESOURCES
We expect our available cash and cash equivalents, short-term investments and short-term restricted cash of $9.9 million at March 31, 2004, funds provided by the sale of our products, contract revenue, and borrowing under equipment financing arrangements will be adequate to fund our operations through at least December 2004, assuming revenue reaches projected levels and cost containment measures continue to be effective. In addition, we plan to continue to evaluate various strategic opportunities, including among others, research and development collaborations, international alliances and marketing partnerships.
We have funded our operations since inception primarily through public and private sales of common and preferred stock, equipment financing arrangements, product revenue and contract revenue. In particular, we have completed three private financings since our initial public offering in May 2000. Although we expect our operating and capital resources will be sufficient to meet future requirements through at least December 2004, we may have to raise additional funds to continue the development and commercialization of future technologies and our business operations in general. These funds may not be available on favorable terms, or at all. If adequate funds are not available on commercially reasonable terms, we may be required to curtail operations significantly or sell significant assets and may not be able to continue as a going concern. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe that we have sufficient funds for current or future operating plans.
Net cash provided by operating activities was $0.4 million for the three months ended March 31, 2004. Net cash used in operating activities was $0.7 million for the three months ended March 31, 2003. Cash flows from operating activities can vary significantly due to various factors including changes in accounts receivable, accrued liabilities and deferred revenue related to new arrangements with customers. The average collection period of our accounts receivable as measured in days sales outstanding (DSO) can vary and is dependent on various factors, including the type of revenue (i.e. patient testing, pharmaceutical company testing or contract revenue), the payment terms related to those revenues, and whether the related revenue was recorded at the beginning or ending of a period.
Net cash used in investing activities of $11,000 for the three months ended March 31, 2004 resulted primarily from capital expenditures of $0.2 million and costs associated with acquiring other assets of $0.1 million, offset by $0.3 million in proceeds from maturities and sales of short-term investments. Net cash used in investing activities of $0.3 million for the three months ended March 31, 2003 resulted from capital expenditures and costs associated with acquiring other assets.
Net cash used in financing activities of $0.1 million and $0.6 million for the three months ended March 31, 2004 and 2003, respectively, resulted primarily from payments on loans and capital lease obligations.
At March 31, 2004, we leased one building which covers 41,000 square feet in South San Francisco, California. The lease expires in April 2010 and provides us with an option to extend the term for an additional ten years. In addition, at March 31, 2004, we subleased approximately 14,000 square feet in South San Francisco, California. This sublease expires on December 31, 2004.
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In March 2004, we terminated a lease for our original laboratory and office space of approximately 25,000 square feet in South San Francisco, California. Under the terms of the lease termination agreement, we recorded a charge of $433,000 primarily related to the termination payment and the write-off of the net carrying value of the related leasehold improvements. This early termination enabled us to eliminate operating expenses related to this lease going forward and reduce our aggregate remaining obligation by approximately half.
In June 2002, we assigned a lease of excess laboratory and office space and transferred ownership through the sale of related leasehold improvements and equipment to a third party. We received net proceeds from the lease assignment of $3.8 million, resulting in a net gain of $0.3 million which is included in accrued liabilities and other long-term liabilities and is recognized as other income over the sublease term. In the event of default by the assignee, we would be contractually obligated for payments under the lease of: $0.8 million in 2004; $1.4 million in 2005; $1.5 million in 2006; $1.5 million in 2007; $1.5 million in 2008; and $3.9 million from 2009 through 2011.
At March 31, 2004, our contractual obligations for the next five years and thereafter, excluding the lease assignment guarantee discussed above, are as follows:
Payments Due By Period | ||||||||||||||||||||
Less Than | ||||||||||||||||||||
1 Year | 2-3 Years | 4-5 Years | Thereafter | Total | ||||||||||||||||
(In thousands) | ||||||||||||||||||||
Operating leases | $ | 1,222 | $ | 1,950 | $ | 2,066 | $ | 1,153 | $ | 6,391 | ||||||||||
Capital leases | 265 | 42 | 20 | — | 327 | |||||||||||||||
Loans | 54 | — | — | — | 54 | |||||||||||||||
Total | $ | 1,541 | $ | 1,992 | $ | 2,086 | $ | 1,153 | $ | 6,772 | ||||||||||
In addition, we are obligated to pay dividends to the Series A preferred stockholders. See “Capital Stock” note to the financial statements for further discussion.
The contractual obligations discussed above are fixed costs. If we are unable to generate sufficient cash from operations to meet these contractual obligations, we may have to raise additional funds. These funds may not be available on favorable terms or at all.
RISK FACTORS
You should carefully consider the following factors and other information in this Form 10-Q when considering our company and its stock.
We may incur future losses and may not achieve profitability as soon as expected, which may cause our stock price to fall.
We have experienced significant losses each year since our inception and may incur additional losses. We experienced net losses applicable to common stockholders of approximately $1.3 million in the three month period ended March 31, 2004, $9.3 million for the year ended December 31, 2003 and $33.3 million for the year ended December 31, 2002. As of March 31, 2004, we had an accumulated deficit of approximately $107.5 million. We may continue to incur losses primarily as a result of spending related to:
• | Expanding patient and pharmaceutical company sample processing capabilities | |||
• | Research and product development costs | |||
• | Sales and marketing activities | |||
• | Additional clinical laboratory and research space and other necessary facilities | |||
• | General and administrative costs |
If our history of losses continues, our stock price may fall and you may lose part or all of your investment.
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Our stockholders will experience substantial additional dilution if our shares of preferred stock or their related warrants are converted into or exercised for shares of common stock. As of March 31, 2004, our outstanding shares of preferred stock and related warrants were convertible into or exercisable for up to an aggregate of 14,811,578 shares of common stock, or approximately 28% of the number of shares of outstanding common stock.
As of March 31, 2004, we had 53,425,292 shares of common stock outstanding. However, as of March 31, 2004, we also had outstanding the following shares of preferred stock and related warrants:
• | 274 shares of Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”), convertible into 2,468,468 shares of common stock (not including the conversion of accrued but unpaid premiums) |
• | warrants issued to the purchasers of our preferred stock in connection with our preferred stock financings to purchase 12,343,110 shares of common stock |
Together, the common shares reserved for issuance upon conversion of the Series A Preferred Stock and upon exercise of the warrants referenced above, represent approximately 14,811,578 shares of common stock, or 28% of the outstanding shares of our common stock at March 31, 2004, all of which are issuable for an approximate weighted-average effective price of $1.15 per share.
The number of shares of common stock that we may be required to issue upon conversion of the Series A Preferred Stock, and exercise of the warrants granted to purchasers of our Series A Preferred Stock in connection with the issuance thereof, can increase substantially upon the occurrence of several events, including if:
• | We issue shares of stock (with certain exceptions) for an effective price less than the conversion price of the Series A Preferred Stock or the related warrants (each $1.11 as of March 31, 2004) |
• | We fail to have sufficient shares of common stock reserved to satisfy conversions, exercises and other issuances |
• | We fail to honor requests for conversion, or notify any holder of Series A Preferred Stock of our intention not to honor requests for conversion |
• | We fail to issue shares upon exercise of the warrants |
• | We fail to redeem any shares of Series A Preferred Stock when required |
We are also obligated to issue additional shares of common stock every six months to the holders of the Series A Preferred Stock as “premium payments.” As of March 31, 2004, these issuances equaled about 198 shares of common stock for every share of Series A Preferred Stock outstanding at the time the issuance is made. This number of shares will increase every six months, by about 33 shares of common stock for each share of Series A Preferred Stock, up to a maximum of about 231 shares of common stock for every share of Series A Preferred Stock. All of the previous share totals are based upon an assumed stock price of $3.03, which was the closing price of our stock on the Nasdaq National Market on March 31, 2004, but the actual number of shares will be based upon our stock price from time to time as of the payment dates. If the 274 shares of the Series A Preferred Stock outstanding as of March 31, 2004 remain outstanding for five years following such date, we will be required to issue as premium payments an additional 623,960 shares of common stock (again based on an assumed stock price of $3.03) to holders of the Series A Preferred Stock, which is 1.17% of the shares of common stock outstanding as of March 31, 2004. We do not receive payment or other consideration for these issuances.
All of the foregoing issuances of common stock would be substantially dilutive to the outstanding shares of common stock, especially where, as described above, the shares of common stock are issued without additional consideration. We cannot predict whether or how many additional shares of our common stock will become issuable due to these provisions.
Any dilution or potential dilution may cause our stockholders to sell their shares, which would contribute to a downward movement in the stock price of our common stock. Any downward pressure on the trading price of our common stock could encourage investors to engage in short sales, which could further contribute to a downward trend in the price of our common stock.
We may be obligated to redeem our Series A Preferred Stock.
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Holders of our Series A Preferred Stock have the right, under certain circumstances, to require us to redeem for cash all of the preferred stock that they own. The redemption price for the Series A Preferred Stock is the greater of (i) 115% of the original purchase price plus 115% of any accrued premium payment thereon and (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. As of March 31, 2004, there were 274 shares of Series A Preferred Stock outstanding, with an aggregate redemption price equal to approximately $3.2 million.
Shares of Series A Preferred Stock are redeemable by the holders of the respective series in any of the following situations:
• | If we fail to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrants and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws | |||
• | If we fail to have sufficient shares of common stock reserved to satisfy conversions of the series | |||
• | If we fail to honor requests for conversion, or if we notify any holder of such series of our intention not to honor future requests for conversion | |||
• | If we institute voluntary bankruptcy or similar proceedings | |||
• | If we make an assignment for the benefit of creditors, or apply for or consent to the appointment of a receiver or trustee for us or for a substantial part of our property or business, or such a receiver or trustee shall otherwise be appointed | |||
• | If we sell all or substantially all of our assets | |||
• | If we merge, consolidate or engage in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K | |||
• | If we commit a material breach under, or otherwise materially violate the terms of, the transaction documents entered into in connection with the issuance of such series | |||
• | If the registration statements covering shares of common stock underlying the Series A Preferred Stock and related warrants cannot be used by the respective selling security holders for the resale of all the underlying shares of common stock for an aggregate of more than 30 days | |||
• | If our common stock is not tradable on the NYSE, the AMEX, the Nasdaq National Market or the Nasdaq SmallCap market for an aggregate of twenty trading days in any nine month period | |||
• | If 35% or more of our voting power is held by any one person, entity or group | |||
• | If we fail to pay any indebtedness in excess of $350,000 when due, or if there is any event of default under any agreement that is likely to have a material adverse effect on us | |||
• | Upon the institution of involuntary bankruptcy proceedings |
Upon the occurrence of any of the events described above, individual holders of the Series A Preferred Stock would have the option, while such event continues, to require us to purchase some or all of the then outstanding shares of Series A Preferred Stock held by such holder. If we receive any notice of redemption, we are required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when we received the redemption notice and the amount of preferred stock covered by the notice. Redemption of the Series A Preferred Stock in any event described above would require us to expend a significant amount of cash that could exceed our total available cash and cash equivalents and could negatively impact our ability to operate our business or raise additional capital. See the notes to the financial statements for further details.
In the event that we need to raise additional capital, our stockholders could experience substantial additional dilution. If such financing is not available on commercially reasonable terms, we may have to significantly curtail our operations or sell significant assets and may be unable to continue as a going concern.
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As of March 31, 2004, we had available cash and cash equivalents, short-term investments and short-term restricted cash of $9.9 million. We anticipate that our existing capital resources together with funds from the sale of our products, contract revenue and borrowing under equipment financing arrangements will enable us to maintain currently planned operations through at least December 31, 2004. However, we may need additional funding sooner than that. To the extent operating and capital resources are insufficient to meet our obligations, including lease payments and future requirements, we will have to raise additional funds to continue the development, commercialization and expansion of our technologies. Our inability to raise capital would seriously harm our business and product development efforts. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. However, we cannot guarantee that additional financing, in any form, will be available at all, or on terms acceptable to us. If we sell equity or convertible debt securities to raise additional funds, our existing stockholders may incur substantial dilution and any shares so issued will likely have rights, preferences and privileges superior to the rights, preferences and privileges of our outstanding common and preferred stock. In the event financing is not available in the time frame required, we will be forced to reduce our operating expenses, curtail sales and marketing activities, reschedule research and development projects or delay, scale back or eliminate some or all of our activities. Further, we might be required to sell certain of our assets or obtain funds through arrangements with third parties that require us to relinquish rights to certain of our technologies or products that we would seek to develop or commercialize ourselves. These actions, while necessary for the continuance of operations during a time of cash constraints and a shortage of working capital, could make it difficult or impossible to implement our long-term business plans or could affect our ability to continue as a going concern.
Our testing products may not achieve market acceptance, which could limit our future revenue.
Our ability to establish phenotypic resistance testing as the standard of care to guide and improve the treatment of viral diseases will depend on physicians’ and clinicians’ acceptance and use of phenotypic resistance testing. Phenotypic resistance testing is still relatively new. We cannot predict the extent to which physicians and clinicians will accept and use phenotypic resistance testing. They may prefer competing technologies and products. The commercial success of phenotypic resistance testing will require demonstrations of its advantages and potential economic value in relation to the current standard of care, as well as to competing products. We have introduced two products using our proprietary PhenoSense technology, PhenoSense HIV and PhenoSense GT, which we began actively marketing in November 1999 and November 2001, respectively. We are still in the early stages of development of new products applying our PhenoSense technology to other viral diseases. If PhenoSense HIV or PhenoSense GT is not accepted in the marketplace, our ability to sell other PhenoSense products would be undermined. Market acceptance will depend on:
• | Our marketing efforts and continued ability to demonstrate the utility of PhenoSense in guiding anti-viral drug therapy, for example, through the results of retrospective and prospective clinical studies |
• | Our ability to demonstrate the advantages and potential economic value of our PhenoSense testing products over current treatment methods and other resistance tests |
If the market does not accept phenotypic resistance testing, or our PhenoSense products in particular, our ability to generate revenue will be limited.
Our revenues will be diminished if changes are made to the way that our products are reimbursed, or if government or third-party payors limit the amounts that they will reimburse for our current products, or do not authorize reimbursement for our planned products.
Government and third-party payors, including Medicare and Medicaid require that we identify the services we perform using industry standard codes known as the Current Procedural Terminology (“CPT”) codes, which are developed by the American Medical Association (“AMA”). Most payors maintain a list of standard reimbursement rates for each such code, and our ability to be reimbursed for our services is therefore effectively limited by our ability to describe the services accurately using the CPT codes. From time to time, the AMA changes its instructions about how our services should be coded using the CPT codes. If these changes leave us unable to accurately describe our services or are not coordinated with payors such that corresponding changes are made to the payors’ reimbursement schedules, we may have to renegotiate our pricing and reimbursement rates, the changes may interrupt our ability to be reimbursed, and/or the overall reimbursement rates for our services may decrease dramatically. In addition, we may spend significant time and resources to minimize the impact of these changes on reimbursement.
Government and third-party payors are attempting to contain or reduce the costs of healthcare and are challenging the prices charged for medical products and services. In addition, increasing emphasis on managed care in the United States will continue to put
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pressure on the pricing of healthcare products. This could in the future limit the price that we can charge for our products. This could also hurt our ability to generate revenues. Significant uncertainty exists as to the reimbursement status of new medical products like the products we are currently developing, particularly if these products fail to show demonstrable value in clinical studies. Currently, nearly all public and a majority of private payors have approved the reimbursement of our existing products. However, the majority of our payors are currently reimbursing our products at varying levels from 70% to 100% of our list prices. If government and other third-party payors do not continue to provide adequate coverage and reimbursement for our testing products or do not authorize reimbursement for our planned products, our revenues will be reduced.
Billing complexities associated with health care payors may result in increased bad debt expense, which could impair our cash flow and limit our ability to reach profitability.
Billing for laboratory services is complex. Laboratories must bill various payors, such as Medicare, Medicaid, insurance companies, doctors, employer groups and patients, all of whom have different requirements. Billing difficulties often result in a delay in collecting, or ultimately an inability to collect, the related receivable. This impairs cash flow and ultimately reduces profitability if we are required to record bad debt expense for these receivables. Most of the bad debt expense is the result of noncredit related issues, primarily missing or incorrect billing information on requisitions. We perform the requested tests and report test results regardless of incorrect or missing billing information. We subsequently attempt to obtain any missing information and rectify incorrect billing information received from the healthcare provider. Missing or incorrect information on requisitions slows the billing process, creates backlogs of unbilled requisitions and generally increases the aging of accounts receivable. Among many other factors complicating billing are:
• | Pricing differences between our fee schedules and those of the payors | |||
• | Changes in or questions about how products are to be identified in the requisitions | |||
• | Disputes between payors as to which party is responsible for payment | |||
• | Disparity in coverage among various payors | |||
• | Difficulties of adherence to specific compliance requirements and procedures mandated by various payors |
Ultimately, if all issues are not resolved in a timely manner, the related receivables are charged to the allowance for doubtful accounts.
We may encounter problems or delays in processing tests, or in expanding our automated testing systems, which could impair our ability to grow our business, generate revenue and achieve and sustain profitability.
In order to meet future projected demand for our products and fully utilize our current clinical laboratory facilities, we estimate that we will have to continue to expand the volume of patient samples that we are able to process. We are also continuing to develop our quality-control procedures and to establish more consistency with respect to test turnaround so that results are delivered in a timely manner. Thus, we need to continue to develop and implement additional automated systems to perform our tests. We have installed several information systems over the past few years, including enterprise resource and laboratory information systems, to support the automated tests, analyze the data generated by our tests and report the results. If these systems do not work effectively as we scale up our processing of patient samples, we may experience processing or quality-control problems and we may experience delays or failures in our operations. These problems, delays or failures could adversely impact the promptness and accuracy of our transaction processing, which could impair our ability to grow our business, generate revenue and achieve and sustain profitability. We have experienced periods during which processing of our test results was delayed, resulting in a temporary backlog of tests to be performed, as was the case in the fourth quarter of 2003. While we take steps to minimize the likelihood of any delays, future delays and backlog may nevertheless occur.
We face intense competition, and if our competitors’ existing products or new products are more effective than our products, the commercial opportunity for our products will be reduced or eliminated.
The commercial opportunity for our products will be reduced or eliminated if our competitors develop and market new testing products that are superior to, or are less expensive than, our phenotypic and/or genotypic resistance testing products we develop using our proprietary technology. The biotechnology industry evolves at a rapid pace and is highly competitive. Our major competitors
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include manufacturers and distributors of phenotypic drug resistance technology, such as Tibotec-Virco (division of Johnson & Johnson) and Specialty Laboratory. We also compete with makers of genotypic tests such as Applied Biosystems Group, Visible Genetics Inc. (division of Bayer Diagnostics) and laboratories performing genotypic testing as well as other genotypic testing referred to as virtual phenotyping. Each of these competitors is attempting to establish its test as the standard of care. Tibotec-Virco’s phenotypic and genotypic tests have been commercially available for a longer time than has PhenoSense HIV or GeneSeq HIV. Genotypic tests are cheaper and generally faster than phenotypic resistance tests. Our competitors may successfully develop and market other testing products that are either superior to those that we may develop or that are marketed prior to marketing of our testing products. Some of our competitors have substantially greater financial resources and research and development staffs than we do. In addition, some of our competitors have significantly greater experience in developing products, and in obtaining the necessary regulatory approvals of products and processing and marketing products.
We derive a significant portion of our revenues from a small number of customers and our revenues may decline significantly if any major customer cancels or delays a purchase of our products.
Our revenues to date and for the foreseeable future consist largely of sales of our PhenoSense products. It is likely that we will continue to have significant customer concentration. Our customers are not typically required to purchase tests from us under long-term contracts, and may stop ordering tests from us at any time. The loss of any major customer, a slowdown in the pace of increasing physician and physician group sales as a percentage of sales, or the delay of significant orders from any significant customer, even if only temporary, could have a significant negative impact on our revenues and our ability to fund operations from revenues, generate cash from operations or achieve profitability.
Various testing materials that we use are purchased from single qualified suppliers, which could result in our inability to secure sufficient materials to conduct our business.
We purchase some of the testing materials used in our laboratory operations from single qualified suppliers. Although these materials could be purchased from other suppliers, we would need to qualify the suppliers prior to using their materials in our commercial operations. Although we believe we have ample inventory stock to allow validation of another source, in the event of a material interruption of these supplies, the quantity of our stock may not be adequate. Any extended interruption, delay or decreased availability of the supply of these materials could prevent us from running our business as contemplated and result in failure to meet our customers’ demands. If significant customer relationships were harmed by our failure to meet customer demands, our revenues may decrease. We might also face significant additional expenses if we are forced to find alternate sources of supplies, or change materials we use. Such expenses could make it more difficult for us to attain profitability, offer our tests at competitive prices and continue our business as currently conducted or at all.
We are dependent on licenses for technology we use in our resistance testing, and our business would suffer if these licenses were terminated.
We license technology that we use in our PhenoSense and GeneSeq tests from Roche. We hold a non-exclusive license for the life of the patent term of the last licensed Roche patent. Currently, the last Roche patent expires in 2005. However, if additional patents are identified that would be necessary or useful for our operations, such patents could be added to the license at our option, which may extend the term of the license. We believe that many of our competitors, including Tibotec-Virco (division of Johnson & Johnson) and other resistance testing companies, also license this technology on non-exclusive terms. Roche has the right to terminate this license if we fail to pay royalties, make a semi-annual royalty report or participate in proficiency testing. We believe we are in compliance with these requirements. The license allows us to use technology covered by the licensed Roche patents within a broad field that includes all of our currently planned products. If we were to expand our product line beyond the licensed field, however, we would need to negotiate an expansion of the license. In addition, we also license technology from other third parties. If these licenses were to be terminated, we would likely have to change a portion of our testing methodology, which would halt our testing, at least temporarily, and cause us to incur substantial additional expenses.
The intellectual property protection for our technology and trade secrets may not be adequate, allowing third parties to use our technology or similar technologies, and thus reducing our ability to compete in the market.
The strength of our intellectual property protection is uncertain. In particular, we cannot be sure that:
• | We were the first to invent the technologies covered by our patent or pending patent applications |
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• | We were the first to file patent applications for these inventions | |||
• | Others will not independently develop similar or alternative technologies or duplicate any of our technologies | |||
• | Any of our pending patent applications will result in issued patents | |||
• | Any patents issued to us will provide a basis for commercially viable products or will provide us with any competitive advantages or will not be challenged by third parties |
We currently have 19 issued patents and 107 pending applications for additional patents, including international counterparts to our U.S. patents. We have licensed seven patents under the Roche license discussed above. These patents cover a broad range of technology applicable across our entire current and planned product line. Other companies may have patents or patent applications relating to products or processes similar to, competitive with or otherwise related to our products. Patent law relating to the scope of claims in the technology fields in which we operate, including biotechnology and information technology, is still evolving and, consequently, patent positions in our industry are generally uncertain. We cannot assure you that we will prevail in any lawsuits regarding the enforcement of patent rights or that, if successful, we will be awarded commercially valuable remedies. In addition, it is possible that we will not have the required resources to pursue offensive litigation or to otherwise protect our patent rights. We also rely on unpatented trade secrets to protect our proprietary technology. Other companies may independently develop or otherwise acquire equivalent technology or gain access to our proprietary technology.
Our products could infringe on the intellectual property rights of others, which may cause us to engage in costly litigation and, if we are not successful defending any such litigation or we cannot obtain necessary licenses, could cause us to pay substantial damages and prohibit us from selling our products.
Our commercial success depends upon our ability to develop, manufacture, market and sell our products and use our proprietary technologies without infringing the proprietary rights of others. Companies in our industry typically receive a higher than average number of claims and threatened claims of infringement of intellectual property rights, and numerous U.S. and foreign issued patents and pending patent applications owned by others exist in HIV, HCV, HBV and the other fields in which we are selling and/or developing products. We may be exposed to future litigation by third parties based on claims that our products, technologies or activities infringe the intellectual property rights of others. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, which may later result in issued patents that our products or technologies may infringe. There also may be existing patents, of which we are not aware, that our products or technologies may inadvertently infringe. Further, there may be issued patents and pending patent applications in fields relevant to our business, of which we may become aware from time to time, that we believe we do not infringe or that we believe are invalid or relate to immaterial portions of our overall business. We cannot assure you that third parties holding any of these patents or patent applications will not assert infringement claims against us for damages or seeking to enjoin our activities. We also cannot assure you that, in the event of litigation, we will be able to successfully assert any belief we may have as to non-infringement, invalidity or immateriality, or that any infringement claims will be resolved in our favor. Third parties have from time to time threatened to assert infringement or other intellectual property claims against us based on their patents or other intellectual property rights or inform us that they believe we required one or more licenses in order to perform certain of our tests. For instance, we recently entered into a license agreement with the NIH covering certain intellectual property rights. To date, we have not had to incur and do not expect to incur significant costs to defend against or settle threatened claims. However, in the future we may have to pay substantial damages, possibly including treble damages, for infringement if it is ultimately determined that our products infringe a third party’s patents. Further, we may be prohibited from selling our products before we obtain a license, which, if available at all, may require us to pay substantial royalties. Even if infringement claims against us are without merit, defending a lawsuit will take significant time, and may be expensive and divert management attention from other business concerns.
If we do not successfully introduce new products using our technology, we may not sustain long-term revenue growth.
We may not be able to develop and market new resistance testing products for HIV and other serious diseases, including hepatitis. Demand for these products will depend in part on the development by others of additional anti-viral drugs to fight these diseases. Physicians will likely use our resistance tests to determine which drug is best for a particular patient only if there are multiple drug treatment options. Several anti-viral drugs currently are in development but we cannot assure you that they will be approved for marketing, or if these drugs are approved that there will be a need for our resistance tests. If we are unable to develop and market resistance test products for other viral diseases, or if an insufficient number of anti-viral drugs are approved for marketing, we may not sustain long-term revenue growth.
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Our business operations and the operation of our clinical laboratory facility are subject to stringent regulations and if we are unable to comply with them, we may be prohibited from accepting patient samples or may incur additional expense to attain and maintain compliance.
The operation of our clinical laboratory facility is subject to a stringent level of regulation under the Clinical Laboratory Improvement Amendments of 1988. Laboratories must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Our laboratory is also subject to regulation by the state of California and various other states. We have received accreditation by the College of American Pathologists and therefore are subject to their requirements and evaluation. Our failure to comply with applicable requirements could result in various penalties, including loss of certification or accreditation, and we may be prevented from conducting our business as we do now or as we may wish to in the future.
The FDA may impose medical device regulatory requirements on our tests, including possibly premarket approval requirements, which could be expensive and time-consuming and could prevent us from marketing these tests.
In the past, the FDA has not required that genotypic or phenotypic testing conducted at a clinical laboratory be subject to premarketing clearance or approval, although the FDA has stated that it believes its jurisdiction extends to tests generated in a clinical laboratory. We received a letter from the FDA in September 2001 that asserted such jurisdiction over in-house tests like ours, but which also stated the FDA is not currently requiring premarket approval for HIV monitoring tests such as ours provided that the promotional claims for such tests are limited to its analytical capabilities and do not mention the benefit of making treatment decisions on the basis of test results. The FDA letter also asserted that our GeneSeq test had been misbranded due to the use of purchased analyte specific reagents (ASRs), if test reports do not include a statement disclosing that the test has not been cleared or approved by the FDA. We now utilize in-house prepared ASRs in our products. The FDA has indicated in discussions that the focus of the letter was our genotypic tests and not our phenotypic tests, but there is no certainty its focus will remain narrow.
We have had several discussions with the FDA related to its positions set forth in the letter. We do not at this point believe the FDA will require us to take steps that materially affect our business or financial performance, but we cannot guarantee this will remain the case.
We cannot be sure that the FDA will accept the steps we take, or that the FDA will not require us to alter our promotional claims or undertake the expensive and time-consuming process of seeking premarket approval with clinical data demonstrating the sensitivity and specificity of our tests. If premarket approval is required, we cannot be sure that we will be able to obtain it in a timely fashion or at all; and in such event the FDA would have authority to require us to cease marketing tests until such approval is granted.
In general, we cannot predict the extent of future FDA regulation of our business. We might be subject in the future to greater regulation, or different regulations, that could have a material effect on our finances and operations. If we fail to comply with existing or additional FDA regulations, it could cause us to incur civil or criminal fines and penalties, increase our expenses, prevent us from increasing revenues, or hinder our ability to conduct our business.
If we do not comply with laws and regulations governing the confidentiality of medical information, we may lose the state licensure we need to operate our business, and may be subject to civil, criminal or other penalties. Compliance with such laws and regulations could be expensive.
The Department of Human Health and Services, or HHS, has issued final regulations under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”), designed to improve the efficiency and effectiveness of the health care system by facilitating the electronic exchange of information in certain financial and administrative transactions, while protecting the privacy and security of the information exchanged. Three principal regulations have been issued:
• | privacy regulations; |
• | security regulations; and |
• | standards for electronic transactions, or transaction standards. |
We have implemented the HIPAA privacy regulations. In addition, we implemented measures we believe will reasonably and appropriately meet the specifications of the security regulations and the transaction standards.
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These standards are complex, and subject to differences in interpretation. We cannot guarantee that our compliance measures will meet the specifications for any of these regulations. In addition, certain types of information, including demographic information not usually provided to us by physicians, could be required by certain payors. As a result of inconsistent application of requirements by payors, or our inability to obtain billing information, we could face increased costs and complexity, a temporary disruption in receipts and ongoing reductions in reimbursements and net revenues. At this time, we cannot estimate the potential impact of payors implementing (or failing to implement) the HIPAA transaction standards on our cash flows and results of operations.
In addition to the HIPAA provisions described above, there are a number of state laws regarding the confidentiality of medical information, some of which apply to clinical laboratories. These laws vary widely, and new laws in this area are pending, but they most commonly restrict the use and disclosure of medical information without patient consent. Penalties for violation of these laws include sanctions against a laboratory’s state licensure, as well as civil and/or criminal penalties. Compliance with such rules could require us to spend substantial sums, which could negatively impact our profitability.
We may be unable to build brand loyalty because our trademarks and trade names may not be protected.
Our registered or unregistered trademarks or trade names such as the name PhenoSense, PhenoSense GT, PhenoScreen and GeneSeq may be challenged, canceled, infringed, circumvented or declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, which we need to build brand loyalty. Brand recognition is critical to our short-term and long-term marketing strategies especially as we commercialize future enhancements to our products.
Clinicians or patients using our products or services may sue us and our insurance may not sufficiently cover all claims brought against us, which will increase our expenses.
Clinicians, patients and others may at times seek damages from us if drugs are incorrectly prescribed for a patient based on testing errors or similar claims. Although we have obtained liability insurance coverage, we cannot guarantee that liability insurance will continue to be available to us on acceptable terms or that our coverage will be sufficient to protect us against all claims that may be brought against us. We may incur significant legal defense expenses in connection with a liability claim, even one without merit or for which we have coverage.
We may have difficulty managing our growth and attracting and retaining skilled personnel, which could hinder our commercial efforts and impair our ability to compete.
If our management is unable to manage our growth effectively, it is possible that our systems and our facilities may become inadequate. Our success also depends on our continued ability to attract and retain highly qualified management and scientific personnel. If we cannot successfully attract and retain qualified personnel, our research and development efforts could be hindered and our ability to run our business effectively and compete with others in our industry will be harmed. With the exception of Bill Young, our CEO, we do not have employment agreements with any of our employees, and we do not maintain “key man” insurance for any employee. If any of our key employees were to leave, we may incur significant costs searching for a replacement. In addition, we have entered into severance agreements with our officers that would, in some instances, require us to pay severance to such officers upon the termination of their employment. We are not aware that any key employee has plans to retire or leave in the near future.
Decreased effectiveness of equity compensation could adversely affect our ability to attract and retain employees, and proposed changes in accounting for equity compensation could adversely affect earnings.
We have historically used stock options and other forms of equity-related incentives as a key component of our employee compensation packages. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of long-term vesting, encourage employees to remain with us. The Financial Accounting Standards Board and other agencies have proposed, and are currently considering, changes to accounting principles generally accepted in the U.S. that would require us to record a charge to earnings for employee stock option grants and other equity incentives. Moreover, applicable stock exchange listing standards related to obtaining stockholder approval of equity compensation plans could make it more difficult or expensive for us to grant options to employees in the future, which may result in changes in our equity compensation strategy. These and other developments in the provision of equity compensation to employees could make it more difficult to attract, retain and motivate employees, and such a change in accounting rules may adversely impact our future financial condition and operating results.
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We may be subject to litigation, which would be time consuming and divert our resources and the attention of our management.
In November 2002, we implemented a business restructuring plan. With the exception of one, all of the employees terminated in connection with the business restructuring signed a release of claims. We have received correspondence from the former employee that did not sign a release threatening to bring claims against us that stem from that termination. We do not have employee practices liability insurance to cover any potential claims by employees terminated in the reduction of force. Even if we are eventually successful in our defense of this or any other similar claims, the time and money spent may prevent us from operating our business effectively or profitably or may distract our management.
Compliance with changing regulation of corporate governance, public disclosure and accounting matters may result in additional expenses.
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by the SEC and The Nasdaq Stock Market, as well as new accounting pronouncements, are creating uncertainty and additional complexities for companies such as ours. To maintain high standards of corporate governance and public disclosure, we intend to invest all reasonable necessary resources to comply with evolving standards. This investment may result in increased general and administrative expenses and a diversion of management time and attention from strategic revenue-generating and cost management activities.
Our operating results may fluctuate from quarter to quarter, making it likely that, in some future quarter or quarters, we will fail to meet estimates of operating results or financial performance, causing our stock price to fall.
If revenue declines in a quarter, our losses will likely increase or our earnings will likely decline because many of our expenses are relatively fixed. Though our revenues may fluctuate significantly as we continue to build the market for our products, expenses such as research and development, sales and marketing and general and administrative are not affected directly by variations in revenue. In addition, our cost of product revenue could also fluctuate significantly due to variations in the demand for our product and the relatively fixed costs to produce it. We are contractually obligated for rental payments under a building lease assignment through 2011 in the event of default by the assignee. We cannot accurately predict how volatile our future operating results will be because our past and present operating results, which reflect moderate sales activity, are not indicative of what we might expect in the future. As a result it is very difficult for us to forecast our revenues accurately and it is likely that in some future quarter or quarters, our operating results will be below the expectations of securities analysts or investors. In this event, the market price of our common stock may fall abruptly and significantly. Because our revenue and operating results are difficult to predict, period-to-period comparisons of our results of operations may not be a good indication of our future performance.
If a natural disaster strikes our clinical laboratory facility and we are unable to receive and or process our customers’ samples for a substantial amount of time, we would lose revenue.
We rely on a single clinical laboratory facility to process patient samples for our tests, which are received via delivery service or mail, and have no alternative facilities. We will also use this facility for conducting other tests we develop, and even if we move into different or additional facilities they will likely be in close proximity to our current clinical laboratory. Our clinical laboratory and some pieces of processing equipment are difficult to replace and could require substantial replacement lead-time. Our processing facility may be affected by natural disasters such as earthquakes and floods. Earthquakes are of particular significance since our clinical laboratory is located in South San Francisco, California, an earthquake-prone area. Our laboratory and equipment are insured up to $15.3 million against loss or damage in the event of a fire but not in the event of a flood or an earthquake. We also have business interruption insurance that provides coverage up to $25 million for business losses related to fire. Our insurance coverage may not be adequate to cover total losses incurred in a fire. However, even if covered by insurance, in the event our existing clinical laboratory facility or equipment is affected by natural disasters, we would be unable to process patient samples and meet customer demands or sales projections. If our patient sample processing operations were curtailed or ceased, we would not be able to perform our tests, which would reduce our revenues, and may cause us to lose the trust of our customers or market share.
Terrorist acts and acts of war may seriously harm our business and financial condition.
Terrorists acts or acts of war (wherever located around the world) may cause damage or disruption to our company, employees, facilities, partners, suppliers, distributors and resellers, and customers, which could significantly impact our revenues, costs and expenses and financial condition. In addition, as our headquarters and our significant patient populations are located in major
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metropolitan areas of the United States, we may be impacted by actions against the United States. Depending on severity and location, such acts could impact our ability to receive shipments of patient samples or result in a substantial reduction in the number of ordered tests due to the inability of patients to get to their physicians. We will be predominantly uninsured for losses and interruptions caused by terrorist acts and acts of war.
Concentration of ownership among some of our stockholders may prevent other stockholders from influencing significant corporate decisions.
At February 15, 2004, approximately 33% of our common stock was beneficially held by a small number of stockholders including an affiliate of Pfizer, our directors, entities affiliated with our directors and former directors, and our executive officers. In addition, our Series A Preferred Stock is held by a small number of stockholders, some of who also own shares of our common stock and could acquire significant additional shares of common stock by converting shares of preferred stock. Consequently, a small number of our stockholders may be able to substantially influence our management and affairs. If acting together, they would be able to influence most matters requiring the approval by our stockholders, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets and any other significant corporate transaction. The concentration of ownership may also delay or prevent a change in our control at a premium price if these stockholders oppose it. There are also certain approval rights of the Series A Preferred Stock, and the few holders of those shares could prevent certain important corporate actions by not approving those actions.
Our stock price may be volatile, and our stock could decline in value.
The market prices for securities of biotechnology companies in general have been highly volatile and may continue to be highly volatile in the future. Our stock price has fluctuated widely during the last two years from a low of $0.72 per share in September 2002 to a high of $4.40 per share in January 2004. The following factors, in addition to other risk factors described in this section, may have a significant negative impact on the market price of our common stock:
• | Period-to-period fluctuations in financial results | |||
• | Financing activities | |||
• | Litigation | |||
• | Delays in product introduction, launches or enhancements | |||
• | Announcements of technological innovations or new commercial products by our competitors | |||
• | Results from clinical studies | |||
• | Developments concerning proprietary rights, including patents | |||
• | Publicity regarding actual or potential medical results relating to products under development by our competitors or our own products or products under development | |||
• | Regulatory developments in the United States and foreign countries | |||
• | Changes in payor reimbursement policies | |||
• | Economic and other external factors or other disaster or crisis |
A low or volatile stock price may negatively impact our ability to raise capital and to attract and maintain key employees.
We may be required to obtain the consent of the holders of our preferred stock before taking corporate actions, which could harm our business.
Our charter documents require us to obtain the consent of the holders of the Series A Preferred Stock before we may issue securities that have senior or equal rights to the respective series, incur unsecured indebtedness for borrowed money, or take other
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actions with respect to the respective series or other securities. We are also required to obtain the consent of the holders of the Series A Preferred Stock before we amend or modify our certificate of incorporation or bylaws to change any of the rights of such series. To obtain these consents, we would need to get consent from holders of a majority of the outstanding shares of the Series A Preferred Stock.
These obligations, and our complicated capitalization structure in general, might frustrate attempts to remove our board or management by making it difficult to find suitable replacements willing to spend substantial amounts of time and efforts on company matters. Moreover, these obligations may deter a potential acquirer from completing a transaction with us. They may also prevent us from taking corporate actions that would be beneficial to our stockholders and us, such as raising capital. Even if we are not prevented from taking such actions, they might be more expensive to us. This was the case when we issued our Series B Preferred Stock in March 2002, because we had to grant additional warrants to holders of Series A Preferred Stock as consideration in order to secure their consent and waiver concerning the financing and the resulting impact on the Series A Preferred Stock. This was also the case when we issued our Series C Convertible Preferred Stock in November 2002, because we had to agree to exchange the shares of Series B Preferred Stock for notes that were convertible into our Series C Convertible Preferred Stock, and to exchange the warrants associated with shares of Series B Preferred Stock for new warrants as consideration to secure the consent and waiver of the Series B Preferred Stock holders concerning the financing and the resulting impact on their respective preferred stock.
If our stockholders sell substantial amounts of our common stock, the market price of our common stock may fall.
If our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options and warrants and upon the conversion of the Series A Preferred Stock, the market price of our common stock may fall. These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. Sales of a substantial number of shares could occur at any time. This may decrease the price of our common stock and may impair our ability to raise capital in the future.
Provisions of our charter documents and Delaware law may make it difficult for our stockholders to replace our management and may inhibit a takeover, either of which could limit the price investors might be willing to pay in the future for our common stock.
Provisions in our certificate of incorporation and bylaws may make it difficult for our stockholders to replace or remove our current management, and may delay or prevent an acquisition or merger in which we are not the surviving company. In particular:
• | Our Board of Directors is classified into three classes, with only one of the three classes elected each year, so that it would take at least two years to replace a majority of our directors |
• | Our bylaws contain advance notice provisions that limit the business that may be brought at an annual meeting and place procedural restrictions on the ability to nominate directors |
• | Our stockholders are not permitted to call special meetings or act by written consent |
The holders of Series A Preferred Stock also have voting rights relating to many types of transactions, such as the creation or issuance of senior or pari passu equity or debt securities and the payment of dividends or distributions, and are subject to redemption at the option of the holder upon certain mergers, consolidations or other business combinations. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law. These provisions could discourage changes of our management and acquisitions or other changes in our control and otherwise limit the price that investors might be willing to pay in the future for our common stock.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and
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non-government debt securities. Due to the relatively short-term nature of our investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore we have not included quantitative tabular disclosure in this Form 10-Q.
We do not enter into financial investments for speculation or trading purposes and are not a party to financial or commodity derivatives.
We have operated primarily in the United States and all sales to date have been made in U.S. Dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Our Chief Executive Officer and Chief Financial Officer, with the assistance of other members of our management, have evaluated our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this report, and have concluded based on that evaluation that those disclosure controls and procedures are effective. There has been no change in our internal control over financial reporting during the fiscal quarter ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II
Item 1. Legal Proceedings
None.
Item 2. Changes In Securities, Use of Proceeds and Issuer Purchases of Equity Securities
(a) None.
(b) None.
(c) Recent Sales of Unregistered Securities
In January 2004, we issued 15,075 shares of our common stock with a market value of $54,000 as of the date of such issuance as a dividend on certain outstanding shares of Series A Preferred Stock. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act.
In March 2004, we issued 27,814 shares of our common stock with a market value of $83,000 as of the date of such issuance as a dividend on the outstanding shares of Series A Preferred Stock. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act.
(d) None.
(e) None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
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Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit | ||
Number | Caption | |
10.1 | Lease Termination Agreement, dated as of March 22, 2004, by and between Britannia Pointe Grand Limited Partnership and ViroLogic, Inc. | |
31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
32.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) or Rule 15d-14(B) promulgated under the Securities Exchange Act of 1934. |
(b) Reports on Form 8-K
On February 10, 2004, we filed a report on Form 8-K to furnish our earnings release for the fourth quarter and year ended December 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, as amended, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of South San Francisco, County of San Mateo, State of California, on May 4, 2004.
ViroLogic, Inc. | ||||
By: | /s/ William D. Young | |||
William D. Young | ||||
Chief Executive Officer (On Behalf of the Registrant) | ||||
/s/ Karen J. Wilson | ||||
Karen J. Wilson | ||||
Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) |
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EXHIBITS INDEX
Exhibit | ||
Number | Caption | |
10.1 | Lease Termination Agreement, dated as of March 22, 2004, by and between Britannia Pointe Grand Limited Partnership and ViroLogic, Inc. | |
31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
32.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) or Rule 15d-14(B) promulgated under the Securities Exchange Act of 1934. |
31