Clarient 10-Q 2006
For the Transition Period from to
Commission File Number 000-22677
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.)
Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer x
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):
Yes o No x
As of November 1, 2006, 71,135,842 shares of the Registrants common stock were outstanding.
CLARIENT, INC. AND SUBSIDIARIES
Table of Contents
See accompanying notes to condensed consolidated financial statements.
CLARIENT, INC. AND SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements.
CLARIENT, INC. AND SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements.
CLARIENT, INC. AND SUBSIDIARIES
(1) Interim Financial Statements
These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended December 31, 2005 filed with the Securities and Exchange Commission.
The accompanying unaudited condensed consolidated financial statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. All such adjustments are of a normal, recurring nature. Certain amounts have been reclassified to conform to the current period presentation. The results of operations for any interim period are not necessarily indicative of the results to be obtained for a full fiscal year.
The Company reclassified certain prior year amounts in its Condensed Consolidated Statements of Cash Flows to conform to its 2006 presentation. The reclassifications were primarily associated with cash proceeds received from customers electing to purchase their ACIS® equipment following the expiration of their operating lease and the resulting gain on sale of such equipment. These reclassifications resulted in a $1.4 million increase in cash used in operating activities and a corresponding decrease in cash used in investing activities from the amounts previously reported for the nine-month period ended September 30, 2005. These changes did not impact the Companys Condensed Consolidated Balance Sheets or Condensed Consolidated Statements of Operations.
(2) Equity-Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment, (SFAS No. 123(R)). SFAS No. 123(R) revises SFAS No. 123, Accounting for Stock Based Compensation, (SFAS No. 123) and supersedes Accounting Principals Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, (APB No. 25) and its related interpretations. SFAS No. 123(R) requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award. SFAS No. 123(R) also requires measurement of the cost of employee services received in exchange for an award. SFAS No. 123(R) also amends SFAS No. 95, Statement of Cash Flows, to require the excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows. The Company adopted SFAS No. 123(R) using the modified prospective method. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Stock-based compensation related to stock options for which there was no comparable expense recorded in the prior year was $0.3 million, or less than $0.01 per share, and $0.8 million, or $0.01 per share, in the three and nine months ended September 30, 2006, respectively.
The Company has a stock option plan (the Plan) pursuant to which its Board of Directors or a committee of the Board may grant stock options and restricted stock awards to employees, directors and consultants. The Plan authorizes grants of options to purchase up to 9,200,000 shares of authorized but unissued common stock. Stock options granted have terms of up to 10 years and become exercisable in increments over periods of up to five years. Unless otherwise provided in an option agreement, all options terminate three months after termination of the option holders employment or relationship with the Company as a director or consultant except in the case of death or disability, in which case the period is extended to one year. Upon exercise of awards, the Company plans on issuing new shares of common stock. At September 30, 2006, there were 1,474,000 shares available for issuance under the Plan.
Stock-based compensation is recognized in the condensed consolidated statements of operations as follows (in thousands):
SFAS No. 123(R) provides that income tax effects of share-based payments are recognized in the financial statements for those awards that will normally result in tax deduction under existing law. Under current U.S. federal tax law, the Company would receive a compensation expense deduction related to non-qualified stock options only when those options are exercised and vested shares are received. Accordingly, the financial statement recognition of compensation cost for non-qualified stock options creates a deductible temporary difference which results in a deferred tax asset and a corresponding deferred tax benefit in the income statement. The Company does not recognize a tax benefit for compensation expense related to incentive stock options unless the underlying shares are disposed in a disqualifying disposition.
Prior to adopting SFAS No. 123(R), the Company accounted for stock-based compensation in accordance with APB No. 25. Had compensation cost been recognized consistent with SFAS No. 123(R, the Companys consolidated net loss and loss per share for the three and nine months ended September 30, 2005 would have been as follows (in thousands except per-share amounts):
The fair value of the Companys stock-based awards to employees was estimated at the date of grant using the Black-Scholes option-pricing model. The risk-free rate is based on the U.S. Treasury yield curve in effect at the end of the quarter in which the grant occurred. The expected life of stock options granted was estimated using the historical exercise behavior of option holders. Expected volatility was based on historical volatility for a period equal to the stock options expected life. The following assumptions were used to determine fair value:
The weighted-average grant date fair value of options issued by the Company during the three and nine month periods ended September 30, 2006 was $0.57 and $0.78, respectively. The weighted-average grant date fair value of options issued by the Company during the three and nine month periods ended September 30, 2005 was $1.18 and $0.99, respectively.
The Company granted 630,000 awards of stock options to certain management-level employees in the second quarter of 2006. Under the terms of these option awards, 60% of the options will vest if the Company achieves minimum revenue and earnings before interest, taxes, depreciation and amortization performance targets for the fiscal year ending December 31, 2006, as established by the Companys Board of Directors. The remaining 40% of the options will vest pro rata on a monthly basis during the 36 month period beginning on the first anniversary of the date of the grant. The Company has not recorded any compensation expense for the portion of these options vesting based on performance targets during 2006.
Option activity of the Company is summarized as follows:
Restricted stock awards activity for the Company is summarized as follows:
The total intrinsic value of options exercised in the three and nine months ended September 30, 2006 and 2005 was not material. As of September 30, 2006, there was $1.8 million of unamortized compensation expense related to stock options. We expect to recognize this expense over a weighted-average period of 3.1 years. As of September 30, 2006, there was $0.2 million of unrecognized compensation expense related to restricted stock awards. We expect to recognize this expense over a weighted-average period of 2.2 years.
(3) Net Loss Per Share
Basic and diluted net loss per common share is calculated by dividing net loss by the weighted average common shares outstanding during the period. Stock options, restricted stock awards and warrants to purchase an aggregate of 13,774,084 and 10,354,247 shares of common stock were outstanding at September 30, 2006 and 2005, respectively. These stock options and warrants outstanding were not included in the computation of diluted earnings per share because the Company incurred a net loss in all periods presented and hence, the impact would be anti-dilutive.
(4) Business Acquisition
On September 22, 2006, the Company completed its acquisition of substantially all of the assets of Trestle Holdings, Inc. and Trestle Acquisition Corp. (a wholly-owned subsidiary of Trestle Holdings, Inc., (collectively, Trestle) for a cash purchase price of $3.3 million, including $2.8 million paid to Trestle and certain of its creditors, and $0.5 million of acquisition costs. Trestle develops and sells digital tissue imaging and telemedicine applications linking dispersed users and data primarily in the healthcare and pharmaceutical markets. The purchase strategically positions the Company as a leading provider in the anatomical pathology market; integrating image analysis, high speed scanning capabilities and virtual microscopy into one offering. Trestle had 12 employees and had offices in Irvine, California, as well as Pittsburgh, Pennsylvania.
The Company financed the all-cash purchase price and related transaction costs associated with the Trestle acquisition, and the repayment of substantially all of Trestles outstanding debt primarily with the net proceeds from a $3.0 million private placement of common stock (see Note 11).
The acquisition of Trestle was accounted for under the purchase method of accounting. As such, the cost to acquire Trestle was allocated to the respective assets and liabilities acquired based on their estimated fair values as of the closing date. A preliminary allocation of the costs to acquire Trestle has been made to certain assets and liabilities of Trestle based on preliminary estimates. The Company will continue to assess the estimated fair values of the assets and liabilities acquired. The Companys management expects to complete the purchase price allocation during the fourth quarter of 2006. The condensed consolidated financial statements include the results of operations of Trestle subsequent to the closing of the acquisition.
The preliminary allocation of the cost to acquire Trestle is as follows (in thousands):
Assets and liabilities acquired are included in the Companys technology segment. Intangible assets acquired consist of patents and tradenames of approximately $1.5 million, with estimated useful lives of 7 to 10 years, customer relationships of $0.9 million, with estimated useful lives of 15 years, and other intangible assets of approximately $0.4 million, with estimated useful lives of 10 years.
The following unaudited pro forma combined financial information for the three and nine months ended September 30, 2006 and 2005 assumes that the Trestle acquisition was completed as of the beginning of the periods presented (in thousands, except per share data):
(5) Goodwill and Intangible Assets
The Company accounts for intangible assets with indefinite lives, including goodwill, in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, which requires the Company to evaluate these assets for impairment annually, or more frequently if an indication of impairment has occurred. During the three months ended September 30, 2006, the Company recorded goodwill of $0.5 million resulting from the acquisition of Trestle. The purchase price allocation for this acquisition is preliminary and subject to revision as a more detailed analysis and additional information about the fair value of assets and liabilities becomes available. Any change in the fair value of the net assets of Trestle will change the amount of the purchase price allocable to goodwill.
Intangible assets are amortized over the shorter of their respective estimated useful lives or their respective remaining legal lives to their estimated residual values. The following tables provide a summary of the Companys intangible assets with definite useful lives recorded as of September 30, 2006 and December 31, 2005 (in thousands):
The following table summarizes the future estimated annual pretax amortization expense for these assets (in thousands):
(6) Net Investment in Sales-Type Leases
The Company derives a portion of its revenues under leasing arrangements. Such arrangements provide for monthly payments covering the system sale, maintenance and interest. These arrangements meet the criteria to be accounted for as sales-type leases pursuant to SFAS No. 13, Accounting for Leases. Accordingly, the system sale is recognized upon delivery of the system, provided all other revenue recognition criteria are met. Upon the recognition of revenue, an asset is established for the investment in sales-type leases. Maintenance revenue and interest income are recognized monthly over the lease term.
The following lists the components of the net investment in sales-type leases as of September 30, 2006 (in thousands):
(7) Currency Translation
The financial position and results of operations of the Companys foreign subsidiaries are determined using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each quarter-end. Income statement accounts are translated at the average rate of exchange prevailing during the period. The effects of currency translations are included in comprehensive loss.
(8) Comprehensive Loss
The total comprehensive loss is summarized as follows (in thousands):
(9) Business Segments
The Company operates primarily in two business segments: 1) the Services Group delivers critical oncology testing services to community pathologists, biopharmaceutical companies and other researchers; and 2) the Technology Group is engaged in the development, manufacture and marketing of an automated cellular imaging system which is designed to assist physicians in making critical medical decisions. The segments are determined based on products and/or services delivered to customer groups. The Companys chief operating decision maker is the Chief Executive Officer and President. The chief operating decision maker allocates resources and assesses performance and other activities at the operating segment level.
Revenue, gross profit and identifiable assets for our operating segments are as follows (in thousands):
(10) Recent Accounting Developments
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, (SFAS No. 151), an amendment of Accounting Research Bulletin No. 43, Inventory Pricing. SFAS No. 151 requires all companies to recognize a current-period charge for abnormal amounts of idle facility expense, freight, handling costs and wasted materials. The statement also requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. This new standard became effective for fiscal years beginning after June 15, 2005. The Companys adoption of SFAS No. 151 as of January 1, 2006 had no material effect on its consolidated financial position, results of operations or cash flows.
Amortization for Leasehold Improvements
In June 2005, the FASBs Emerging Issues Task Force reached a consensus on Issue No. 05-6, Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination (EITF 05-6). This guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are reasonably assured at the date of the business combination or purchase. This guidance was applicable only to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. The adoption of EITF 05-6 did not have an impact on the Companys consolidated financial position, results of operations or cash flows.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (FIN 48), which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes . FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company has not completed its evaluation of the impact of adopting FIN 48.
(11) Stock Transactions
On November 8, 2005, the Company entered into a securities purchase agreement with a limited number of accredited investors pursuant to which the Company agreed to issue and the investors agreed to purchase 15,000,000 shares of common stock, together with warrants to purchase an additional 2,250,000 shares of common stock at an exercise price of $1.35 per share, for an aggregate purchase price of $15,000,000 (this financing is referred to as the 2005 financing). The warrants issued in this transaction are exercisable for a period of four years after the date they were issued. This transaction was structured so that a portion of the common stock and warrants issued (8,900,000 shares of common stock and warrants to purchase 1,335,000 shares of common stock for aggregate gross proceeds of $8,900,000) were issued at an initial closing that occurred on November 9, 2005. The remaining shares and warrants were issued at a subsequent closing on December 14, 2005. Safeguard Scientifics, Inc. (Safeguard) was one of the purchasers in the 2005 financing and acquired 9,000,000 shares (of which 5,340,000 shares were acquired at the initial closing) of common stock and warrants to purchase 1,350,000 shares of common stock (of which 801,000 were acquired at the initial closing) for an aggregate investment of $9,000,000. Following consummation of the financing, Safeguard beneficially owned approximately 57%
of the Companys outstanding common stock. In connection with the 2005 financing, the Company entered into a registration rights agreement with the purchasers and the Company has registered the resale of the shares issued in the 2005 financing with the Securities and Exchange Commission.
On September 22, 2006, the Company entered into a securities purchase agreement with Safeguard pursuant to which the Company agreed to issue and Safeguard agreed to purchase 4,162,042 shares of common stock, together with warrants to purchase an additional 624,306 shares of common stock at an exercise price of $0.98 per share, for an aggregate purchase price of $3,000,000. The purpose of this transaction was to fund the purchase of Trestle, and is referred to as the Trestle financing. The warrants issued in this transaction are exercisable for a period of four years after the issued date of September 22, 2006. Following consummation of the Trestle financing, Safeguard beneficially owned approximately 59.6% of the Companys outstanding common stock. In connection with this financing, the Company agreed to register the shares purchased by Safeguard upon request by Safeguard.
Due to its beneficial ownership of approximately 59.6% of the Companys outstanding common stock, Safeguard has the power to elect all of the directors of the Company, although Safeguard has contractually agreed with the Company that a majority of the board of directors will consist of individuals not specifically designated by Safeguard. The Company has given Safeguard contractual rights enabling it to exercise significant control over the Company.
(12) Lines of Credit
The Company currently has an $8.5 million revolving credit agreement, which expires on February 28, 2007 and bears interest at the banks prime rate minus one-half percent. The borrowings under the line of credit are being used for working capital purposes and to provide a $3.0 million stand-by letter of credit to the landlord of the Companys Aliso Viejo headquarters. The agreement also includes an annual credit facility fee of $27,500 and one financial covenant related to tangible net worth, which is required to be not less than $0. The Company paid Safeguard a commitment fee of $15,000 and issued to Safeguard a warrant to purchase 50,000 shares of common stock for an exercise price of $2.00 per share as additional consideration for Safeguards $3.0 million increase in the guarantee in August 2005. The Company is also obligated to pay Safeguard an amount equal to 0.5% of the amount guaranteed and 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. At September 30, 2006, the Company had $5.5 million outstanding and no additional availability under the line of credit.
On September 29, 2006, the Company entered into a Loan and Security Agreement with General Electric Capital Corporation (GE Capital). The financing arrangement consists of a senior secured revolving credit facility pursuant to which the Company may borrow up to $5.0 million, subject to adjustment. Borrowings under the credit agreement may not exceed 85% of the Companys qualified accounts receivable after application of certain liquidity factors and deduction of certain specified reserves, and are repaid daily by a sweep of the Companys cash-collections lockbox. The credit agreement includes an annual collateral monitoring fee of $12,000, and also includes affirmative, negative and financial maintenance covenants. The facility has a two-year term and is secured by the diagnostic services business accounts receivable, along with all of the other assets of the Company and its subsidiaries. The interest rate under this financing arrangement is based on the lower of the London Interbank Offered Rate (LIBOR), plus 3.25% or the Wall Street Journal published Prime Rate, plus 0.5%. The credit agreement provides for a prepayment fee of 2.0% of the commitment amount if terminated during the first year and 1.0% of the commitment amount if terminated any time thereafter prior to the maturity date. The Company incurred closing, underwriting deposit fees, and legal fees associated with the credit agreement of $126,000. At September 30, 2006, the Company had borrowed $1.0 million under this $5.0 million facility. Based on the amount of qualified accounts receivable at September 30, 2006, the Company estimated it could borrow approximately $2.0 million of the remaining $4.0 million under the facility as of that date.
As described above, the Company has $5.5 million of outstanding debt on its revolving credit agreement which is due on February 28, 2007. The Company has incurred operating losses and negative cash flows for the past several fiscal periods and has an accumulated deficit of $132.8 million at September 30, 2006. The Company intends to renew its line of credit in 2007, although there can be no assurance that it will be able to renew or obtain additional debt financing when needed or on terms that are favorable to the Company.
(13) Equipment Financing
In June 2004, the Company entered into a master lease agreement with GE Capital for capital equipment financings of diagnostic services (laboratory) related equipment. The Company financed $2.6 million in 2004, $2.3 million in 2005 and $1.9 million in the nine months ended September 30, 2006 of capital equipment under this arrangement, which were recorded as capital lease obligations. Each lease financing has a term of 36 months. The 2004 financings provide for an early purchase option by the Company after 30 months at 26.6% of the cost of the equipment. The 2005 and 2006 financings provide for an early purchase option by the Company after 24 months for an average purchase price equal to 44.8% and 45.2% of the cost of the equipment, respectively. At September 30, 2006, the Company had $1.1 million available for additional 2006 equipment financings under the master lease agreement.
The capital lease obligations as of September 30, 2006 are as follows (in thousands):
(14) Borrowings on Equipment Subject to Operating Leases
On March 1, 2006, the Company entered into a Master Purchase Agreement with Med One Capital Inc. (Med One) pursuant to which Med One purchased certain ACIS® cost-per-test units for a gross amount of $2.3 million, and on August 31, 2006, Med One purchased additional units for a gross amount of $0.4 million. Each unit purchased by Med One was in use by a customer at the time of each transaction. Under the agreement, 10 percent of each purchase price is held in escrow and may be recoverable by Med One to the extent that any units returned to Med One prior to the expiration of the applicable equipment lease are not successfully remarketed. The escrow amount is classified as restricted cash. The proceeds from these financings were recorded as debt, as the transactions did not meet the criteria for recognition of revenue. Amounts invoiced to customers for tests performed or the minimum monthly rental fee related to the units sold to Med One are recorded as revenue, with a portion of these fees recorded as interest expense and the remaining portion recorded as a reduction in the amount recorded as debt. As of September 30, 2006, approximately $0.8 million of the proceeds from the Med One transactions were classified as current liabilities and approximately $1.3 million of the proceeds were classified as non-current liabilities. The Company continues to record depreciation expense on the units sold to Med One which is reflected in cost of revenues.
(15) Commitments and Contingencies
Operating Lease Commitment. The Company utilizes various operating leases for office space and equipment. The Company entered into a lease agreement dated as of July 20, 2005 for a mixed-use building with approximately 78,000 square feet in Aliso Viejo, California. The lease commenced on December 1, 2005 with an initial term of 10 years and an option to extend the lease term for up to two additional five-year periods. The initial annual base rent was approximately $0.5 million. The annual base rent was increased to approximately $1.0 million on June 1, 2006 and as the Company occupies additional square footage, will increase to approximately $1.4 million on December 1, 2008. The base rent is increased 3% annually effective on December 1 of each year beginning in 2006. The Company is also responsible for payments of common area operating expenses for the premises. The landlord has agreed to fund approximately $3.5 million of tenant improvements toward design and construction costs associated with the build-out of the facility of which the landlord has reimbursed the Company $2.9 million through September 30, 2006. Such costs will be capitalized as leasehold improvements and amortized over the shorter of their estimated useful lives or the remaining lease term, while the reimbursement will be recorded to deferred rent and recovered ratably over the term of the lease.
At September 30, 2006, future minimum lease payments for all operating leases are as follows (in thousands):
Construction Agreement. On October 26, 2005, the Company entered into a construction agreement with LCS Constructors, Inc. (LCS), a team of general contractors and construction managers dedicated to the planning, design, construction and facility support of laboratories and technical facilities, to build-out its newly-leased facility in Aliso Viejo, California. Under the terms of the agreement, LCS is required to provide or arrange for construction services, materials, equipment, permits and liability insurance for the construction of the facility. The project is expected to be completed in three phases, with a substantial completion date of December 31, 2005 for the first phase after which time the Company moved its laboratory facilities in January 2006 to the new location. The first two phases of the build-out pursuant to the contract were completed as of September 30, 2006. The total amount paid for phases one and two was $3.6 million and $2.4 million, respectively. Fees for the remaining third phase of the build-out will be included in an amendment to this contract and are estimated to be approximately $360,000. Commencement of the third phase is anticipated for 2008, with the completion date as soon as practicable thereafter. Payments for all phases have been made in installments based on the percentage of completion, with the final payment on each phase being made after LCS has completed the applicable phase in its entirety, all corrective items have been completed and the architect has prepared a final completion notice.
Distribution and Development Agreement with Dako. On July 18, 2005, the Company entered into a distribution agreement with Dako A/S (Dako), a Danish company that provides system solutions for cancer diagnostics and cell analysis worldwide. Under the terms of the agreement, Dako distributes and markets the Companys ACIS® system and related software. The distribution arrangement is exclusive on a worldwide basis in research and clinical markets, and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). The agreement has a five-year initial term.
Dako has agreed to order a minimum of 40 ACIS® systems per contract year, commencing July 1, 2006, subject to certain adjustments. Revenue from systems sold under this agreement will be recognized when these ACIS® systems have been delivered and accepted by Dako. Revenue for certain systems sold for Dakos use as training and demonstration units is recorded when delivered and accepted by Dako.
Dako also agreed to invest research and development funds toward future ACIS® devices and related software, and such products are also subject to the terms of the agreement. The Company will own all intellectual property created under the agreement that is related to image analysis and execution thereof, and Dako will own all intellectual property created under the agreement that is related to Dakos specific implementation of the products or integration of the products with a product supplied by Dako. Such intellectual property will be cross-licensed from one party to the other. In the event the Company fails to supply ACIS® systems as set forth in the agreement, Dako will have the right and license to manufacture the ACIS® systems for that purpose for a reduced fee. Revenues received from research and development agreements are recognized over the contract performance period, starting with the contracts commencement. The Company received an upfront payment of $0.5 million, which was deferred and recognized on a straight-line basis over the estimated performance period. Milestone payments are recognized as revenue when they are earned and collectible, but not prior to the removal of any contingencies for each individual milestone. The final two milestones under this agreement are expected to be earned and collectible in the fourth quarter of 2006.
(16) Recent Developments
Nasdaq Delisting Notice. On July 10, 2006 the Company received a notice from the Nasdaq Listing Qualification Staff (Staff) that the Companys common stock is subject to delisting from the Nasdaq Capital Market as a result of failure to comply with the $1.00 per share bid price requirement for 30 consecutive days as required by Nasdaq Marketplace Rule 4310(c)(4) (the Rule). In accordance with Nasdaq Marketplace Rule 4310(c)(8)(D), the Company will be provided 180 calendar days, or until January 8, 2007, to regain compliance. If at anytime before January 8, 2007, the bid price of the Companys common stock closes at $1.00 per share for 10 consecutive days, the Nasdaq staff will provide written notification that the Company complies with the Rule. If compliance with this Rule cannot be demonstrated by January 8, 2007, the Nasdaq staff will determine whether the Company meets The Nasdaq Capital Market initial listing criteria as set forth in Marketplace Rule 4310(c), except for the minimum bid price requirement. If it meets the other initial listing criteria, the Nasdaq staff will notify the Company that it has been granted another 180 calendar day compliance period. If the Company does not regain compliance with the Rule and is not eligible for an additional compliance period, the Staff will provide written notification that the Company will be delisted and, at that time, the Company may appeal the determination to delist to a Listing Qualifications Panel. As of the date of this filing, the Company has not received notification from Nasdaq that the Company has regained compliance.
This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as managements beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as projects, expects, anticipates, intends, plans, believes, seeks, estimates, should, would, could, will, opportunity, potential or may, variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to, the Companys ability to obtain additional financing on acceptable terms or at all, the Companys ability to successfully integrate Trestles business with its own business, the Companys ability to continue to develop and expand its services group business and its technology group business, the Companys ability to maintain compliance with financial and other covenants under its credit facilities, the Companys ability to execute against its plan of acquisition and subsequent integration of certain technology assets and intellectual property, the performance and acceptance of the Companys instrument systems in the market place, the Companys ability to expand and maintain a successful sales and marketing organization, continuation of favorable third party payer reimbursement for tests performed using the Companys system and for other diagnostic tests, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in developing any new software applications, the Companys ability to successfully sell instruments under its distribution agreement with Dako A/S and to timely complete its next generation Automated Cellular Imaging System (ACIS®) device, failure to obtain Food and Drug Administration (FDA) clearance or approval for particular applications, the Companys ability to compete with other technologies and with emerging competitors in cell imaging and dependence on third parties for collaboration in developing new tests and in distributing the Companys systems and tests performed on the system, and those risks which are discussed in Risk Factors below. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.
Results of Operations
Overview and Outlook
We are an advanced oncology diagnostics technology and services company. Our mission is to combine innovative technologies, meaningful test results and world-class expertise to improve outcomes of patients suffering from cancer. With the completion of the human genome project in the late 1990s, medical science has entered a new era of diagnostics that will move us closer than ever before to understanding the molecular causes for complex diseases, particularly cancer. As a result, the landscape of cancer management is undergoing significant change. There is now an escalating need for advanced oncology testing to provide physicians with necessary information on the cellular profile of a specific tumor, enabling them to select the most appropriate therapies.
In 2004 we began to leverage our core technologies and intellectual properties to commercialize a set of services to provide the community pathologist with the latest in cancer diagnostic technology. Anchored by our own proprietary image analysis technology and augmented by other emerging technologies, we are able to provide a complete assessment of the molecular cause and characteristics of cancer. Our ACIS ® is a versatile automated microscope system that greatly improves the accuracy and reproducibility of digital cell imaging through its unique, patented technology. Our comprehensive laboratory services are focused on in-house pathology testing, using the ACIS ® and other cutting-edge diagnostic technologies to assist physicians in cancer assessment.
In addition, we develop ACIS®-based tools for academic and biopharmaceutical company researchers, allowing them to perform cellular-level analyses much faster and with improved accuracy. A number of the top clinical laboratories, hospitals, university medical centers and biopharmaceutical companies in the U.S. and Europe have adopted our technology. By placing systems in key academic research centers and biopharmaceutical organizations, our systems can be established as a powerful standardization tool for the discovery and clinical trial process by aiding in target and patient selection for these emerging therapies. New tests will also drive higher demand for our specialized, high-end diagnostic services as a result of our expertise in related therapeutics.
We estimate that the market for advanced cancer diagnostic testing will increase from an estimated $1.5 billion today to over $2.5 billion by 2010. This increase is attributable to multiple factors including increasing incidences of cancer in an aging population, new therapies and expanded testing panels. Our previous concentration on image analysis systems limited us to participation in only the instrument systems portion of the market, which we estimate represented less than 10% of this market. Recent trends indicate treatment decisions are likely to involve the assessment of a complex panel of protein and gene based testing rather than a single test. Therefore, diagnostic and predictive testing for these therapies will likely become increasingly complex and there will be increased demand for sophisticated services to either interpret test results or assist pathologists in such interpretations. Our goal is to position ourselves to participate in a substantially greater portion of the cancer diagnostics market by serving the needs of the market from drug discovery through clinical practice with the services offered by our services and technology businesses.
The initial objective of our service strategy had been to support the expansion of the remote pathology program for community pathologists, a large customer segment. The focus of the development of the ACIS ® technology platform has been to assist our customers in their diagnosis and assessment of cancer. We continue to explore numerous ways to leverage our relationship with our customers to better serve their needs and expand revenue opportunities. A logical extension of the remote pathology technical services has been the recent introduction of other esoteric tests and related professional diagnosis that support the oncology services marketplace. We provide a broad spectrum of other laboratory services, including:
· flow cytometry,
· molecular diagnostics including PCR (polymerase chain reaction),
· analysis of tumors of unknown origin, and
· expanded services for immunohistochemistry.
In July 2005, we entered into a distribution and development agreement with Dako A/S (Dako), a Danish company recognized as a worldwide leader in diagnostic pathology testing services. Under the agreement, Dako was appointed our exclusive distributor of the ACIS® system to the clinical marketplace, which includes local hospitals and pathology practices. Dako has agreed to fund new development milestones that, when achieved, will enhance and add new features to our ACIS® system. The Company believes that this program will improve the long-term prospects for the placement of systems in the U. S. and overseas.
Through our combined marketing and sales efforts with Dako, we are focused on the sale of the ACIS® system to clinical and research accounts, which include biopharmaceutical companies, biotechnology companies and academic medical centers. We believe that there are more than 1,000 such research organizations and an equal number of clinical organizations in the U.S. that are good candidates for ACIS®. An important driver of our success in the future will be our ability to develop new diagnostic tests on the ACIS® and duplicate the success and market penetration that has been achieved within the breast cancer testing markets. Working in collaboration with top-tier pharmaceutical companies, we are developing diagnostic tests and related assays that will target new cancer therapies to those patients most likely to benefit from their use.
On September 22, 2006, we completed our purchase of substantially all of the assets of Trestle Holdings, Inc., and Trestle Acquisition Corp. (a wholly-owned subsidiary of Trestle Holdings, Inc.) (collectively, Trestle). The purchase strategically positions us as a leading provider in the anatomical pathology market; integrating image analysis, high speed scanning capabilities and virtual
microscopy into one offering. Complementing our current proprietary ACIS® with Trestles technology enables us to cover virtually all of the pathology samples needing anatomical laboratory analysis. The assets acquired include current product line and inventory, manufacturing capabilities, high speed scanning technology and related intellectual property.
An important component of our strategy is to continue to build and, when necessary, defend our intellectual property position. We file patent applications to protect technology, innovations and improvements that we consider important to the development of our business and we will consider acquisitions of businesses or intellectual property rights that will complement our existing business. We make investments in research and development and unique approaches to the application of new technologies.
Currently, we have 29 patent applications pending with the U.S. Patent and Trademark Office and 11 foreign patent applications pending. We have 29 issued or allowed patents in the U.S. and 11 foreign patents, all related to the system and method for cellular specimen grading performed by the ACIS® or related technologies. The patents for which we have received a final issuance have remaining legal lives that vary from 12 to 19 years. In all our patent applications we have endeavored to file claims which cover the underlying concepts of the unique features of the ACIS ®, its associated processes and methodologies as well as our specific implementation of those processes and methodologies.
As a further protection against efforts to erode our proprietary position, we have systematically explored other designs, which could achieve results similar to the ACIS ® and we have prepared patent applications on those alternate designs. Our research and development efforts have been further validated in the area of automated immunohistochemistry for which we have obtained five FDA 510(k) clearances over the past several years. These clearances help to validate the efficacy of our technology and to broaden the acceptance of our image analysis. It will be important for us to obtain FDA clearances for our portfolio of new diagnostic tests developed in our bioanalytical services development efforts.
Key indicators of our financial condition and operating performance
Our business is complex, and management is faced with several key challenges to reach profitability. We began providing in-house laboratory services in 2004 to give us an opportunity to capture a significant service-related revenue stream from the much broader and expanding cancer diagnostic testing marketplace. The business continues to experience double-digit growth, as a result of the excellent execution of our sales plan and solid market acceptance of our service offerings. Management must manage the growth of this business and provide infrastructure to support it, particularly related to facilities, quality assurance, billing, collections and business processes. We have experienced improved gross margins, but have yet to reach optimal financial metrics related to cash flow and operating margins as we support our growing business.
We also face the challenge of effectively managing the transition from selling ACIS® systems directly to selling them through our distributor, Dako, coupled with the development of a new version of ACIS® developed to Dako specifications. We experienced a slower than expected start-up of the implementation of our distribution arrangement as we transition to the new ACIS® system (ACIS® III). The delayed ramp-up has primarily resulted in our technology business experiencing a 46% decline in revenue from $6.6 million in the first nine months of 2005 to $3.5 million in the nine month period ended September 30, 2006, and a corresponding decline in gross profit from $4.7 million to $2.2 million. We believe that our technology revenue from system sales will increase once ACIS® III is completed and ready for launch, which we expect to occur in the fourth quarter of 2006.
Selling, general and administrative (SG&A) expenses, including diagnostic services administration, in the nine month period ended September 30, 2006 were 82% of total revenue, compared to 102% in the nine month period ended September 30, 2005. We expect this improving trend will continue as our revenues increase, offsetting our initial investments in: 1) selling expenses related to the ramp-up of our sales force responsible for our diagnostics services; 2) diagnostic services administration, particularly the costs of pathology services; 3) implementing the Dako distribution arrangement; 4) key business development initiatives focused on targeted cancer therapies in various stages of clinical study using our proprietary imaging technology; and 5) the build-out of our new state-of-the art laboratory facility in Aliso Viejo, California.
Finally, we are dependent on the use of both debt and equity financing to fund our operating losses in the near term and to sustain our growth pattern in the future. Management believes that our existing cash resources and anticipated revenues from instrument sales to Dako following the launch of our ACIS® III device, together with access to our financing sources described below, will be sufficient to satisfy the cash needs of our existing operations throughout 2007. Our financing sources include our revolving line of credit with General Electric Capital Corporation (GE Capital). As of September 30, 2006, we had borrowed $1.0 million under this revolving credit line. The facility provides that we could borrow up to an additional $4.0 million, depending on the amount of our qualified accounts receivable and other liquidity factors at the time of borrowing (of which we estimate we could borrow approximately $2.0 million as of September 30, 2006 based on the amount of our qualified accounts receivable as of that date). We also have up to $1.1 million of availability under our equipment lease line with GE Capital (which remains subject to GE Capitals ongoing review of our financial condition at the time of each funding request and approval of each funding request). Additionally, we intend to renew our $8.5 million revolving line of credit with Comerica Bank-California (Comerica), which expires on February 28, 2007.
Characteristics of our revenue and expenses
Services Group Billing. Revenues for our services group are derived primarily from billing insurers, pathologists and patients for the diagnostic services that we provide.
Third party billing. The majority of revenue currently generated by our services group is for patients that utilize insurance coverage from Medicare or other third party insurance companies. In these situations, we bill an insurer that pays a percentage of the amount billed based on several factors including the type of coverage (for example, HMO or PPO), whether the charges are considered to be in network or out of network, and the amount of any co-pays or deductibles that the patient may have at that time. The rates that are billed are typically a percentage of those amounts allowed by Medicare for the service provided as defined by Common Procedural Terminology (CPT) codes. The amounts that are paid to us are a function of the payers practice for paying claims of these types and whether we have specific agreements in place with the payers. We also have a Medicare provider number that allows us to bill and collect from Medicare.
Client (pathologist) billing. In some situations, we establish direct billing arrangements with our clients where we bill them for an agreed amount per test for the services provided and the client will then handle all billing directly with the private payers. The amount that may be charged to our clients is determined in accordance with applicable state and federal laws and regulations.
Patient billing. Less than 20% of our billings are billed directly to patients. These billings can result from co-payment obligations, patient deductibles, circumstances where certain tests are not covered by insurance companies, and patients without any health insurance.
Technology Group Revenue. Revenues for our technology group are derived from fee-per-use, ACIS® sales and development revenue. We have been experiencing a shift in this revenue model since 2004 as we complete various financing arrangements with third-parties and strategic alliances with key distributors such as Dako.
Services Group Cost of Revenue and Gross Margin. Cost of revenue includes laboratory personnel, laboratory-related depreciation expense, laboratory supplies and other direct costs such as shipping. Most of our cost of revenue structure is variable, except for staffing and related expenses which are semi-variable and depreciation which is mostly fixed.
Technology Group Cost of Revenue and Gross Margin. The cost of revenue primarily consists of cost for manufacturing the ACIS®, including the cost for direct material, labor, manufacturing overhead, and direct customer support. For fee-per-use revenue, the cost of the ACIS® is depreciated over three-years and for a system sale or sales-type lease the entire cost of the ACIS® system is recognized at the time of sale. Most of our cost of revenue structure is fixed, except for variable costs of materials and overhead related to ACIS® units sold.
Operating expenses include selling, general and administrative expenses, diagnostic services administration and research and development. Expenses within this category primarily consist of the salaries, benefits and costs attributable to the support of our operations, such as: investments in information systems, expenses and office space costs for executive management, sales and marketing expenses, financial accounting, purchasing, administrative and human resources personnel, recruiting fees, legal, auditing and other professional services.
The majority of our current sales resources are dedicated to the growing diagnostic services business. Targeting community pathology practices and hospitals, the sales process for this business group is designed to understand the customers needs and develop appropriate solutions from our range of laboratory service options.
We also have a dedicated instrument systems sales organization. To ensure the success of our joint commercial efforts, this team is now solely focused on assisting the Dako sales team in targeting, selling and closing instrument placements in both the clinical and research markets as image analysis specialists.
Diagnostic services administration includes the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation and support the operations of the diagnostic services segment. Collection costs are incurred from a third party billing and collection company that we have engaged to perform these services due to the high degree of technical complexity and knowledge required to effectively perform these operations. These costs are incurred as a percentage of amounts collected.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and the disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented. Therefore, on an ongoing basis, we evaluate our estimates, including those provisions for bad debts, inventory reserves and other accrued liabilities.
For estimated bad debts, we review individual accounts and groups of payers based on the age of the receivable, all circumstances surrounding the transaction that gave rise to the receivable and whether the customer or payer continues to have the
financial resources to pay the receivable as of the balance sheet date and prior to the issuance of the financial statements for the related period. This process is followed for both our instrument and laboratory accounts. We have outsourced the direct billing and collection of laboratory related receivables and work closely with our outsourced billing partner to review the details of each laboratory account.
Inventory, Long-Lived Assets and Accruals
For ACIS® inventory and work in progress, the respective reserve is based upon the expected future use of the ACIS® components and whether there are any lower of cost or market considerations. Laboratory services inventories represent primarily chemicals and supplies used in the testing process.
We review our long-lived assets, such as fixed assets and intangibles, for impairment whenever events or changes indicate the carrying value may not be recoverable or that the useful lives are no longer appropriate. If we determine that the carrying value of the long-lived assets may not be recoverable, the asset is then written down to its estimated fair value based on a discounted cash flow basis. Included in long-lived assets are ACIS® units on lease to third parties under operating leases, which are recorded in property and equipment.
For other obligations requiring managements use of estimates, we review the basis for assumptions about future events and conditions, which are inherently subjective and uncertain. In determining whether a contingent liability should be accrued, Management applies standards under Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, under which we accrue a contingent liability if the exposure is considered probable and reasonably estimable.
Goodwill and Indefinite-Lived Intangible Assets
We test goodwill and indefinite-lived intangible assets for impairment in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. We perform these tests annually in the second quarter of each year. Additionally, we may perform tests between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. See Note 5 in the accompanying Notes to Condensed Consolidated Financial Statements. An impairment, if any, would be recorded in operating income and could significantly adversely affect net income and earnings per share.
Revenue for our diagnostic services is recognized at the time of completion of services at amounts equal to the contractual rates allowed from third parties, including Medicare, insurance companies, and to a small degree, private patients. These expected amounts are based both on Medicare allowable rates and our collection experience with other third party payers. Because of the requirements and nuances of billing for laboratory services, we generally invoice amounts from a standard or customer-specific agreed upon fee schedule. Differences in payments expected from third party payers and our standard fee schedule are recorded as contractual discounts. Only the expected payment from these parties, net of these contractual discounts, is recorded as revenue.
Revenue for fee-per-use agreements is obtained through the billing information via modem, which accesses the ACIS® database. Revenue is recognized based on the greater of actual usage fees or the minimum monthly rental fee. Under this pricing model, we own or retain a substantial risk of ownership of most of the ACIS® instruments that are engaged in service and accordingly, all related depreciation and maintenance and service costs are expensed as incurred. For those instruments that are sold, we recognize and defer revenue using the residual method pursuant to the requirements of Statement of Position (SOP) No. 97-2, Software Revenue Recognition (SOP No. 97-2), as amended by SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition with Respect to Certain Arrangements. At the outset of the arrangement with the customer, we defer revenue for the fair value of its undelivered elements (e.g., maintenance) and recognize revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (e.g., software license and related instrument) when the basic criteria in SOP No. 97-2 have been met. Maintenance revenue is recognized ratably over the term of the maintenance contract, which typically is a period of twelve months. We do not recognize revenue on sales of assets subject to an operating lease where we retain a substantial risk of ownership.
Revenue on system sales is recognized in accordance with Staff Accounting Bulletin (SAB) No. 101, as amended by SAB No. 104, when all criteria for revenue recognition have been met. Such criteria include, but are not limited to: existence of persuasive evidence of an arrangement; fixed or determinable product pricing; satisfaction of the terms of the arrangement including passing title and risk of loss to our customer upon shipment; and reasonable assurance of collection from our customer in accordance with the terms of the arrangement. For system sales delivered under the Dako distribution and development agreement, we recognize revenue when those ACIS® instruments have been delivered and accepted by an end-user customer. Revenue for certain systems sold for Dakos use as training and demonstration units is recorded when delivered and accepted by Dako.
Systems sold under a leasing arrangement are accounted for as sales-type leases pursuant to SFAS No. 13, Accounting for Leases, if applicable. We recognize the net effect of these transactions as a sale because of the bargain purchase option granted to the lessee.
Revenues from research and development agreements are recognized over the contract performance period, starting with
the contracts commencement. Upfront payments are generally deferred and recognized on a straight-line basis over the estimated performance periods. Milestone payments are recognized as revenue when they are earned and collectible, but not prior to the removal of any contingencies for each individual milestone.
Three Months Ended September 30, 2006 Compared with Three Months Ended September 30, 2005
The following table presents our results of operations as percentages of revenue:
Total revenue for the third quarter 2006 was $9.1 million compared to $4.9 million for the third quarter 2005, an increase of 86% or $4.2 million.
Services Group. Revenue from our services group increased 162% or $4.9 million from $3.0 million in the third quarter of 2005 to $7.9 million in the third quarter ended September 30, 2006. This increase resulted from the execution of our marketing and sales strategy to increase our sales to additional new customers and to enter into new managed care contracts. This increase was also driven in part by increasing the number of available tests being performed that include immunohistochemistry, flow cytometry, and florescent in-situ hybridization (FISH). We anticipate that diagnostic services revenues will continue to increase as a result of increased revenue from existing customers, additional penetration of new customers (including managed care providers) by our sales force and our offering of a more comprehensive suite of advanced cancer diagnostic tests.
Technology Group. Revenue from our technology group in the third quarter 2006, including fee-per-use, system-sales and development revenue, was $1.2 million, compared to $1.9 million in the third quarter 2005, a decrease of approximately $0.7 million or 37%. The change is primarily the result of a decrease in instrument systems revenue from $0.9 million for the third quarter 2005 to $0.6 million for the quarter ended September 30, 2006, and a decline in per click revenue of $0.4 million, from $1.0 million to $0.6 million in the comparable three month period. We expect technology services revenue to increase going forward as a result of milestone payments earned for the development of a new generation of the ACIS® system and the sale of systems through the Dako distribution agreement (particularly from the planned launch of ACIS® III in the fourth quarter of 2006).
Cost of Revenue and Gross Margin
For the third quarter 2006 and 2005, our gross margin was 46% and 41%, respectively.
Services Group. Cost of revenue for the quarter ended September 30, 2006 was $4.4 million compared to $2.3 million for the third quarter of 2005. These costs included laboratory personnel, laboratory equipment depreciation expense, laboratory supplies and other direct costs such as shipping. Gross margin for our services group for the third quarter 2006 was 45%, compared to 23% for the third quarter 2005. The improvement in gross margin in the third quarter of 2006 was attributable to achieving economies of scale in our diagnostics laboratory operations. We anticipate similar gross margin results in future periods.
Technology Group. Cost of revenue was $0.6 million for the third quarter 2006 and 2005. The cost of revenue primarily
consisted of the costs of manufacturing the ACIS®, including the cost for direct material, labor, manufacturing overhead and direct customer support. For fee-per-use revenue, the cost of the ACIS® is depreciated over three-years and for a system sale or sales-type lease the entire cost of the ACIS® system is recognized at the time of sale. Gross margins for our technology group were 53% for the third quarter ended September 30, 2006 compared to 70% for the third quarter ended September 30, 2005. This decrease in gross margin was a result of lower than expected sales volume combined with the anticipated lower per-system sales price as we moved to our distributor sales arrangement with Dako.
Operating and Other Expenses
Selling, general and administrative expenses. Expenses for the third quarter 2006 increased approximately $0.7 million, or 19%, to $4.4 million compared to $3.7 million for the comparable period in 2005. However, these costs declined as a percentage of revenues from 76% in the third quarter 2005 to 48% in the third quarter 2006. The increase in expenses in the current quarter was primarily due to increases in rent expense related to our new facility, increases in selling expenses to support the growing diagnostics services business, and higher stock-based compensation expense due to the implementation of SFAS No. 123 (revised 2004), Share-Based Payment, (SFAS No. 123(R)). We anticipate sales expenses to support our growing diagnostics services business will continue to grow consistent with future revenue growth, and expect general and administrative expenses to decline as a percentage of revenues as our infrastructure costs continue to stabilize.
Diagnostic services administration. These costs totaled $2.3 million for the third quarter 2006 compared to $1.6 million in the third quarter of 2005, an increase of 46%. These costs include senior medical staff, senior operations personnel, collections, consultants and legal resources to facilitate implementation and support the operations of the diagnostic services segment. The increase was primarily due to higher collection costs due to the increase in services group revenues. These costs are expected to continue to increase for future periods, relative to prior periods, because of higher diagnostic services revenues.
Research and development expenses. Research and development expenses for the three months ended September 30, 2006 increased by approximately $0.1 million or 14%, over the comparable period in 2005. This increase was primarily attributable to personnel and consultants supporting the development activity under our agreement with Dako. While development expenses are higher, we earn development fees under the terms of our distribution and development agreement with Dako which are recognized in revenue. These development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS ® and increase the utility of the ACIS ® as a tool for researchers, are important to increasing clinical system test volume, expanding the number of clinical system placements and increasing research systems sales. We expect development expenses to continue at similar levels at least until completion of ACIS ® III, which is expected to launch in the fourth quarter of 2006.
Other expense and income taxes. These expenses for the three months ended September 30, 2006 totaled $0.3 million, compared to $0.1 million for the comparable period in 2005, and consisted of approximately $0.3 million of net interest expense (after offsetting interest income). Interest expense increased from approximately $0.1 million in the third quarter 2005 to approximately $0.3 million in the third quarter 2006, due to the increased borrowings under our financing facilities and the debt-guarantee fee charged by Safeguard Scientifics (Safeguard). We expect interest expense to continue to increase as our borrowings under our financing facilities increase.
Nine Months Ended September 30, 2006 Compared with Nine Months Ended September 30, 2005
The following table presents our results of operations as percentages of revenue:
Total revenue for the nine month period ended September 30, 2006 was $23.4 million compared to $14.1 million for same period of 2005, an increase of 65% or $9.2 million.
Services Group. Revenue from our services group increased 162% or $12.2 million from $7.6 million in the first nine months of 2005 to $19.8 million in the nine month period ended September 30, 2006. This increase resulted from the execution of our marketing and sales strategy to increase our sales to additional new customers and to enter into new managed care contracts. This increase was also driven in part by increasing the number of available tests being performed that include immunohistochemistry, flow cytometry, and florescent in-situ hybridization (FISH). We anticipate that diagnostic services revenues will continue to increase as a result of increased revenue from existing customers, additional penetration of new customers (including managed care providers) by our sales force and our offering of a more comprehensive suite of advanced cancer diagnostic tests.
Technology Group. Revenue from our technology group in the nine month period ended September 30, 2006, including fee-per-use, instrument system-sales and development revenue, was $3.5 million, compared to $6.6 million in the first nine months of 2005, a decrease of approximately $3.1 million or 46%. The change was primarily the result of a decrease of $2.0 million in instrument systems revenue from $3.3 million in the nine months ended September 30, 2005 to $1.3 million for the nine months ended September 30, 2006 (a decrease of 61%) and a decline in per click revenue of $1.5 million from $3.3 million to $1.8 million in the comparable nine month period (a decrease of 45%). This decline was partially offset by an increase in development revenue in the nine months ended September 30, 2006 of $0.4 million compared to no development revenue in the same period of 2005. We expect technology group revenue will increase for the remainder of 2006 as a result of the sale of systems through the Dako distribution agreement (particularly from development fees earned through milestone payments under the Dako development agreement and the planned launch of ACIS® III in the fourth quarter of 2006).
Cost of Revenue and Gross Margin
For the nine month period ended September 30, 2006, our gross margin was 47% compared to 43% for the third quarter 2005.
Services Group. Cost of revenue for the nine months ended September 30, 2006 was $11.1 million compared to $6.2 million for the comparable period of 2005, an increase of 79%. As a percentage of services revenue, however, our services group cost of revenue improved from 82% in the nine month period ended September 30, 2005 to 56% in the nine month period ended September 30, 2006. These costs included laboratory personnel, lab-related depreciation expense, laboratory supplies and other direct costs such as shipping. Gross margin for our services group for the first nine months of 2006 was 44%, compared to 18% for the same period of 2005. The increase in gross margin in the first nine months of 2006 was attributable to achieving economies of scale in our diagnostics laboratory operations. We anticipate similar gross margin results for the remaining quarter of 2006.
Technology Group. Cost of revenue was $1.4 million for the nine months ended September 30, 2006 compared to $1.8 million for the nine months ended September 30, 2005. The cost of revenue primarily consisted of the costs of manufacturing the ACIS ® , including the cost for direct material, labor, manufacturing overhead, and direct customer support. For fee-per-use revenue, the cost of the ACIS ® is depreciated over three-years and for a system sale or sales-type lease the entire cost of the ACIS ® system is recognized at the time of sale. Gross margins for our technology group were 61% in the nine months ended September 30, 2006 and 72% in the nine month period ended September 30, 2005. This decrease in gross margin was a result of lower than expected sales volume combined with the anticipated lower per system sales price as we moved to our distributor sales arrangement with Dako.
Operating and Other Expenses
Selling, general and administrative expenses. Expenses for the nine months ended September 30, 2006 increased approximately $3.0 million, or 30%, to $12.8 million compared to $9.8 million for the comparable period in 2005. As a percent of revenues, these costs decreased from 70% in the nine month period of 2005 to 55% in the nine month period ended September 30, 2006. The increase in expenses in the first nine months of 2006 was primarily due to increases in rent expense related to our new facility, increases in selling expenses to support the growing diagnostics services business, higher stock-based compensation expense due to the implementation of SFAS No. 123(R) and relocation and recruiting related expenses. We anticipate sales expenses to support our growing diagnostics services business will continue to grow throughout the remaining quarter of 2006, and expect general and administrative expenses to decline as a percentage of revenues as our infrastructure costs stabilize.
Diagnostic services administration. These costs totaled $6.4 million for the nine month period ended September 30, 2006 compared to $4.5 million in the nine month period ended September 30, 2005, which included the costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation and support the operations of the diagnostic services segment. The increase was primarily due to higher collection costs due to an increase in services group revenue for the period, and the addition of medical and administrative staff to support this rapidly growing segment of our business. These costs are expected to continue to increase due to higher collection costs on an anticipated continued increase in services group revenue.
Research and development expenses. Expenses for the nine months ended September 30, 2006 increased by approximately $0.8 million or 29%, over the comparable period in 2005 from $2.7 million to $3.4 million. This increase was primarily attributable to personnel and consultants supporting the development activity under our agreement with Dako. While development expenses are higher, we earn development fees under the terms of our distribution and development agreement with Dako which are recognized in revenue. These development activities, which are intended to produce features that could expand the volume of clinical tests supported by ACIS ® and increase the utility of the ACIS® as a tool for researchers, are important to increasing clinical system test volume, expanding the number of clinical system placements and increasing research systems sales. We expect development expenses to continue at similar levels until completion of ACIS® III, which is expected to launch in the fourth quarter of 2006.
Other expense and income taxes. These expenses for the nine months ended September 30, 2006 totaled $0.7 million, compared to $0.2 million for the comparable period in 2005, and consisted of approximately $0.8 million of net interest expense and $19,000 of income tax expense, offset by approximately $0.1 million of interest income. The increase in interest expense is due to the increased borrowings under our financing facilities and the debt-guarantee fee charged by Safeguard. We expect interest expense to continue to increase as our borrowings under our financing facilities increase.
Liquidity and Capital Resources
At September 30, 2006, we had approximately $2.3 million of cash and cash equivalents and approximately $2.0 million of additional borrowing available under our revolving lines of credit (based on our estimated qualified accounts receivable borrowing base as of that date). Cash used in operating activities was $9.8 million for the nine month period ended September 30, 2006 due primarily to our net loss of $12.5 million, the net increase in our accounts receivable of $4.0 million from the beginning of the period, partially offset by increases in other accruals. Cash used in investing activities of $8.4 million consisted of $5.4 million used to fund capital expenditures related primarily to purchases of new equipment for the diagnostic services laboratory and leasehold improvements at the new facility. These expenditures were partially offset by $1.8 million of net cash provided by capital lease financing, $6.5 million of cash provided by our lines of credit and $2.5 million of net cash provided by financing from Med One Capital, Inc. (Med One), as described below.
In July 2005, we signed a ten-year lease for a new, single facility which began December 1, 2005 with two five-year renewal options. We relocated our laboratory operations to the new facility in January 2006 and relocated our corporate headquarters and manufacturing operation to the new facility in the second quarter 2006. The landlord of the new facility agreed to fund approximately $3.5 million of tenant improvements, subject to the terms of the lease agreement. Our total projected spending for the build-out of the facility is approximately $8.4 million. As of September 30, 2006, we have spent approximately $7.5 million on tenant improvements and equipment purchases to build out the facility. We expect to spend approximately $0.9 million to complete the facility project. Of the $7.5 million spent through September 30, 2006, the landlord has funded approximately $2.9 million and we expect the landlord to fund the balance of approximately $0.6 million as we complete the remaining tenant improvements of the new facility. The lease for our former corporate headquarters and manufacturing facility expired in June 2006.
Our instrument systems business generates revenues from leases of the ACIS® system to certain customers (pursuant to which those customers pay us on a fee-per-use basis for each time the instrument is used to perform a test) and from sales of our ACIS® systems. Revenues from system leases are recognized over the lease term and revenues from system sales are recognized upon customer acceptance of the system. We do not anticipate leasing a significant number of new ACIS® systems on a going forward basis. Instead, we expect that sales of our ACIS® system to new customers will comprise the substantial majority of new system placements. These sales will include sales of systems pursuant to our distribution arrangement with Dako and direct sales by us in markets where our distribution arrangement with Dako is not exclusive. The rate of inventory purchases as it relates to ACIS® equipment purchases has been lower than prior periods due to the slower pace of system placements. However, as a result of our distribution arrangement with Dako, we expect sales of systems to increase during the remainder of 2006 and that the rate of related inventory purchases will also increase. We also expect our research and development expenditures to continue at similar levels until completion of our ACIS® III system. Future ACIS® system development expenses will be offset in part by revenue earned from Dako under the terms of our distribution and development arrangement.
We currently have an $8.5 million revolving credit agreement with Comerica, which expires on February 28, 2007. The borrowings under the line of credit are being used for working capital purposes and a $3.0 million stand-by letter of credit that was provided to the landlord of our new leased facility and bears interest at the banks prime rate minus 0.5% percent. The agreement also includes an annual facility fee of $27,500 and has only one financial covenant related to tangible net worth, which is required to be not less than $0. Borrowings under the line of credit are guaranteed by Safeguard in exchange for an annual fee of 0.5% of the amount guaranteed and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding under the line of credit. We also issued a warrant to Safeguard to purchase 50,000 shares of common stock for an exercise price of $2.00 per share as additional consideration for Safeguards guarantee. Exclusive of the $3.0 million stand-by letter of credit, at September 30, 2006, we did not have any availability under the line of credit. We anticipate that we will renew this line of credit prior to the February 28, 2007 maturity date.
On September 29, 2006, we entered into a revolving credit facility with GE Capital. The financing arrangement consists of a senior secured revolving credit facility pursuant to which we may borrow up to $5.0 million, subject to adjustment. Borrowings under the credit agreement may not exceed 85% of our qualified accounts receivable
after application of certain liquidity factors and deduction of certain specified reserves, and are repaid daily by a sweep of our cash-collections lockbox. The credit agreement includes an annual collateral monitoring fee of $12,000, and also includes affirmative, negative and financial maintenance covenants. The facility has a two-year term and is secured by the diagnostic services business accounts receivable, along with all of our other assets the assets of our subsidiaries. The interest rate under this financing arrangement is based on the lower of the London Interbank Offered Rate (LIBOR), plus 3.25% or the Wall Street Journal published Prime Rate, plus 0.5%. The credit agreement provides for a prepayment fee of 2.0% of the commitment amount if terminated during the first year and 1.0% of the commitment amount if terminated any time thereafter prior to the maturity date. We incurred closing, underwriting deposit fees, and legal fees associated with the credit agreement of $126,000. At September 30, 2006, we had borrowed $1.0 million under this $5.0 million facility. Based on the amount of our qualified accounts receivable at September 30, 2006, we estimate we could borrow approximately $2.0 million of the remaining $4.0 million under the facility as of that date.
In June 2004, we entered into a master lease agreement with GE Capital for capital equipment financings of diagnostic services (laboratory) related equipment. We financed $2.6 million in 2004, $2.3 million in 2005 and $1.9 million through September 30, 2006 of capital equipment under this arrangement, which were recorded as capital lease obligations. Each lease financing has a term of 36 months. At September 30, 2006, the company had $1.1 million available for additional 2006 equipment financings under the master lease agreement. The 2004 financings provide us with an early purchase option after 30 months at 26.6% of the original cost of the equipment. The 2005 and 2006 financings provide us with early purchase options after 24 months for average purchase prices equal to 44.8% and 45.2% of the original cost of the equipment, respectively. We believe that we have substantially all of the laboratory equipment that is required to support our current operating activities. A substantial increase in diagnostic service activity in excess of our annual revenue plan may result in a requirement to make additional capital expenditures. We expect to fund any purchases of additional laboratory equipment from our 2006 equipment financing lease line.
On March 1, 2006, we entered into a Master Purchase Agreement with Med One pursuant to which Med One purchased ACIS® cost-per-test units that we previously leased to customers for a gross amount of $2.3 million, and on August 31, 2006, Med One purchased additional units for a gross amount of $0.4 million. Under the agreement, 10 percent of each purchase price is held in escrow and may be recoverable by Med One to the extent that any units returned to Med One prior to the repayment of Med Ones net investment in the applicable equipment lease are not successfully remarketed. The proceeds from these financings were recorded as debt. Amounts invoiced to customers for tests performed or the minimum monthly rental fee related to the units sold to Med One are recorded as revenue. A portion of each fee is recorded as interest expense and the remainder reduces the amount recorded as debt. We continue to record depreciation expense on the units sold to Med One which is recorded to cost of revenues.
On September 22, 2006 we completed our acquisition of substantially all of the assets of Trestle. As part of the agreement, we purchased certain assets of Trestle, including high speed scanning technology, virtual systems, related intellectual property, a current product line, inventory, and manufacturing capabilities, and assumed certain liabilities of Trestle. The purchase price for the assets was approximately $3.3 million in cash, including $0.5 million of acquisition costs. In conjunction with the acquisition, we paid $2.8 million of cash to Trestle and its creditors. We financed this transaction primarily with the $3.0 million of net proceeds from the equity financing with Safeguard described below.
On September 22, 2006, we entered into a securities purchase agreement with Safeguard pursuant to which we agreed to issue and Safeguard agreed to purchase 4,162,042 shares of common stock, together with warrants to purchase an additional 624,306 shares of common stock at an exercise price of $0.98 per share, for an aggregate purchase price of $3,000,000. The purpose of this financing was to fund the purchase of Trestle, and is referred to as the Trestle financing. The warrants issued in this transaction are exercisable for a period of four years after the issued date of September 22, 2006. Following consummation of the Trestle financing, Safeguard beneficially owned approximately 59.6% of the Companys outstanding common stock. In connection with this financing, we agreed to register the shares purchased by Safeguard upon request by Safeguard.
We believe that our existing cash resources and anticipated revenues from our laboratory services business and from instrument sales to Dako following the launch of our ACIS® III device, together with continued access to our financing sources described above and our anticipated renewal of our line of credit with Comerica will be sufficient to satisfy the cash needs of our existing operations throughout 2007. However, if we are unable to access one or more of these financing sources, if we are unable to renew our $8.5 million revolving line of credit with Comerica upon expiration on February 28, 2007, if sales of our ACIS® III device are lower than anticipated or if we encounter other difficulties in executing our business plan, we may require additional financing. Additionally, if we reach a decision to acquire or license complementary technology or acquire complementary businesses, we would require additional debt or equity financing, or would be required to monetize other assets. There can be no assurance that we will be able to obtain additional debt or equity financing when needed or on terms that are favorable to us and our stockholders. Furthermore, if additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.
The following table summarizes our contractual obligations and commercial commitments at September 30, 2006, including our new operating facility lease and capital lease obligations. These commitments exclude any remaining amounts necessary to complete the build-out of our new facility and a $3.0 million standby letter of credit provided to the landlord under the lease agreement for our new facility.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that provide financing, liquidity, market or credit risk support or involve leasing, hedging or research and development services for our business or other similar arrangements that may expose us to liability that is not expressly reflected in the financial statements, except for facilities operating leases.
As of September 30, 2006, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such we are not subject to any material financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
New Accounting Standards
Several new accounting standards have been issued and adopted. Except for SFAS No. 123(R), none of these standards had a material impact on our financial position, results of operations, or liquidity.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (FIN 48), which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes . FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company has not completed its evaluation of the impact of adopting FIN 48.
Risks Related to Our Business
Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and other reports we have filed with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks are realized, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.
We have limited experience in providing laboratory and other services, which may cause us to experience difficulties that could delay or prevent the development, introduction and marketing of these services.
We began providing the technical component of reference laboratory services in-house beginning in April 2004 and we began to provide additional oncology-focused laboratory services that complement our image analysis and certified Access reference laboratory services in December 2004. The success and viability of these initiatives is dependent on a number of factors including:
· our ability to develop and provide services that we have provided only for a relatively short time;
· adequate reimbursement;
· medical efficacy as demonstrated by clinical studies and governmental clearances;
· governmental clearances, governmental regulations and expansion of the menu of tests performed by ACIS® to bring greater economies of scale to our accounts operations; and
· our ability to obtain timely renewal of state and federal regulatory licenses.
We may not be successful in any of these areas, we may experience difficulties that could delay or prevent the successful development, introduction and marketing of these services, and we may not adequately meet the demands of the marketplace or achieve market acceptance. Our inability to accomplish any of these endeavors may have a material adverse effect on our business, operating results, cash flows and financial condition.
Our instrument business is highly dependent on the efforts of our distribution partners and on increased market penetration of the ACIS®, and it is uncertain whether the ACIS® will achieve that penetration.
Increased market acceptance of the ACIS® depends on a number of variables, including, but not limited to, the following:
· acceptance of our next generation ACIS® device in the marketplace;
· the ability of the ACIS® to perform as expected;
· acceptance by patients, physicians, third party payers and laboratories of the ACIS® to run the tests performed using it;
· our ability to develop a significant number of tests performed with the ACIS®;
· the amount of reimbursement by third party payers for a test performed using the ACIS®;
· our ability to expand our diagnostic laboratory service initiative;
· the effectiveness of our marketing, distribution and pricing strategy;
· availability of alternative and competing diagnostic products; and
· scientific studies and other publicity concerning ACIS® or competitive products.
The future commercial success of our products will depend primarily on convincing research, reference and clinical laboratories to evaluate and offer these products as research tools for scientists and clinical investigators and as diagnostic products to physicians, laboratory professionals and other medical practitioner and convincing physicians, laboratory professionals and other medical practitioners to order tests for their patients involving our technologies. To accomplish this, we will need to convince oncologists, pathologists and other members of the medical and biotechnology communities of the benefits of our products. Additionally, if ongoing or future clinical trials result in unfavorable or inconsistent results, these products may not achieve market acceptance. Even if the efficacy of our future products and services are established, physicians may elect not to use them for a number of reasons. These reasons might include the training required for their use or unfavorable reimbursement from health care payers. We have entered into and intend to continue to enter into corporate collaborations for the development of new applications, clinical collaborations with respect to tests using the ACIS® and strategic alliances for the distribution of the ACIS® and our other products, including products we may develop in the future. In July 2005, we entered into a distribution and development agreement with Dako, which is exclusive in research and clinical markets and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). We therefore depend upon the success of Dako to distribute our ACIS® products and perform their responsibilities under our collaborative arrangements. The transition from selling ACIS® systems directly to selling them through Dako has been challenging. We experienced a slower than expected start-up of the implementation of our distribution arrangement with Dako. The delayed ramp-up of this selling arrangement has resulted in our technology business experiencing a 46% decline in revenue from $6.6 million in the first nine months of 2005 to $3.5 million in the first nine months of 2006, and a corresponding decline in gross profit from $4.7 million to $2.2 million. We believe that the ramp-up of business from this relationship will improve in the final quarter of 2006 and in 2007 once ACIS® III is launched. If our arrangement with Dako is not successful, the marketability of our products and services may be limited and our technology could become underfunded and obsolete relative to new, emerging technologies of companies that have greater financial resources. We cannot assure you that we will be able to enter into additional arrangements that may be necessary in order to develop and commercialize our products, or that we will realize any of the contemplated benefits from existing or new arrangements.
We have a history of operating losses, and our future profitability is uncertain.
We have incurred operating losses in every year since inception, and our accumulated deficit as of September 30, 2006 was $132.8 million. Those operating losses are principally associated with the research and development of our ACIS® technology, the start-up and early operations of our diagnostics laboratory business, the conducting of clinical trials, preparation of regulatory clearance filings, the development of Dakos sales and marketing organization to commercialize the ACIS® and the capital investments we have made relating to our recently launched diagnostic services business. We may not be able to achieve profitable operations at any time in the future.
Because our operating expenses are likely to increase in the near term, we will need to generate significant additional revenue to achieve profitability. We expect to continue to incur losses as a result of the expansion of the laboratory services, ongoing research and development expenses, as well as increased sales expenses. We are unable to predict when we will become profitable, and we may never become profitable. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to achieve and then maintain profitability, the market value of our common stock may decline.
We recently completed our acquisition of substantially all of the assets of Trestle and may acquire other businesses, products or technologies in order to remain competitive in our market and our business could be adversely affected as a result of any of these future acquisitions.
On September 22, 2006 we completed our acquisition of substantially all of the assets of Trestle. We financed this transaction primarily with the net proceeds from a private placement of 4,162,042 shares of common stock, purchased by Safeguard. The integration of the Trestle business with our existing business could cause significant diversions of management time and resources. Our business, financial condition and results of operations could be materially adversely affected if we are unable successfully integrate the acquired assets with our business.
We may make other acquisitions of complementary businesses, products or technologies. If we identify any additional appropriate acquisition candidates, we may not be successful in negotiating acceptable terms of the acquisition, financing the acquisition, or integrating the acquired business, products or technologies into our existing business and operations. Further, completing additional acquisitions and integrating acquired businesses will further significantly divert management time and resources. The diversion of management attention and any difficulties encountered in the transition and integration process could harm our business. If we consummate any significant acquisitions using stock or other securities as consideration, our shareholders equity
could be significantly diluted. If we make any significant acquisitions using cash consideration, we may be required to use a substantial portion of our available cash. Acquisition financing may not be available on favorable terms, if at all. In addition, we may be required to amortize significant amounts of other intangible assets in connection with future acquisitions, which would harm our operating results, cash flows and financial condition.
We just completed relocation of our business and are making significant expenditures in connection therewith.
We recently relocated our diagnostic services laboratory, corporate headquarters and manufacturing facilities to a new facility in Aliso Viejo, California. Unexpected consequences of the recent relocation to the Aliso Viejo facility could create risk of business interruption and could require substantial capital investment.
We may require additional financing for, among other things, funding our operating losses, planned expansion of our laboratory operations, capital expenditures and other costs related to the move to a new facility, acquisition transactions and expenses associated with our anticipated increase in placements of our ACIS® systems and it is uncertain whether such financing will be available on favorable terms, if at all.
We believe that our existing cash resources and anticipated revenues from our laboratory services business and from instrument sales to DAKO following the launch of our ACIS® III device, together with access to additional borrowings under our revolving credit facility with GE Capital (the amount of which will depend on the amount of our qualified accounts receivable borrowing base and other liquidity factors) and our equipment lease line with GE Capital (which remains subject to GE Capitals ongoing review of our financial condition at the time of each funding request and approval of each funding request) and our anticipated renewal of our line of credit with Comerica will be sufficient to satisfy the cash needs of our continuing operations throughout 2007. However, if we are unable to access one or more of these financing sources, if we are unable to renew our $8.5 million revolving line of credit with Comerica upon expiration on February 28, 2007, if sales of our ACIS® III device are lower than anticipated or if we encounter other difficulties in executing our business plan, we may require additional financing. Additionally, if we reach a decision to acquire or license complementary technology or acquire complementary businesses, we would require additional debt or equity financing, or would be required to monetize other assets. There can be no assurance that we will be able to obtain additional debt or equity financing when needed or on terms that are favorable to us and our stockholders. Furthermore, if additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.
Our present and future funding requirements will also depend on certain other external factors, including, among other things:
· the level of research and development investment required to maintain and improve our technology position;
· costs of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights;
· our need or decision to acquire or license complementary technologies or acquire complementary businesses;
· competing technological and market developments; and
· changes in regulatory policies or laws that affect our operations.
We do not know whether additional financing will be available on commercially acceptable terms when needed. If adequate funds are not available or are not available on commercially acceptable terms, we might be required to delay, scale back or eliminate some or all of our development activities, new business initiatives, clinical studies or regulatory activities or to license to third parties the right to commercialize products or technologies that we would otherwise seek to commercialize ourselves. If additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.
Our strategy for the development and commercialization of the ACIS® platform contemplates collaborations with third parties, making us dependent on their success.
We do not have the ability to independently conduct the clinical trials required to obtain regulatory clearances for our applications, but rely on third-party expert clinical investigators and clinical research organizations to perform these functions. If we cannot locate and enter into favorable agreements with acceptable third parties, or if these third parties do not successfully carry out their contractual obligations, meet expected deadlines or follow regulatory requirements, including clinical laboratory, manufacturing and good clinical practice guidelines, then we may be the subject of an enforcement action by the FDA or other regulatory bodies, and may be unable to obtain clearances for our products or to commercialize them on a timely basis, if at all.
We are required to comply with financial and other covenants in our debt financing agreements, and our ability to engage in certain business transactions may be limited by the restrictive covenants of our debt financing agreements.
Our existing financing agreements with Comerica and GE Capital contain financial covenants requiring us to meet financial ratios and financial condition tests, as well as covenants restricting our ability to:
· incur additional debt;
· pay dividends or make other distributions or payments on capital stock;
· make investments;
· incur or permit to existing liens;
· enter into transactions with affiliates;
· change business, legal name or state of incorporation;
· guarantee the debt of other entities, including joint ventures;
· merge or consolidate or otherwise combine with another company; and
· transfer or sell our assets.
These covenants could adversely affect our ability to finance our future operations or capital needs and pursue available business opportunities, including acquisitions. A breach of any of these covenants could result in a default in respect of the related indebtedness. If a default occurs, the relevant lenders could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. We believe that we are currently in compliance with the covenants in our financing agreements.
We have limited commercial manufacturing capacity and may encounter difficulties as we undertake to manufacture our system in increasing quantities.
We may encounter significant delays and incur significant unexpected costs in scaling-up our manufacturing operations. In addition, we may encounter delays and difficulties in hiring and training the workforce necessary to manufacture the ACIS ® in the increasing quantities required for us to achieve profitability. The failure to scale-up manufacturing operations successfully, in a timely and cost-effective manner, could have a material adverse effect on our revenues and income. We believe that we have adequate manufacturing capacity to meet anticipated demand for 2006. However, in order to meet demand thereafter, we will have to expand our manufacturing processes and manpower or rely on third-party manufacturers. We might encounter difficulties in expanding our manufacturing processes and hiring qualified personnel or in developing relationships with third-party manufacturers. If we are unable to overcome these difficulties our ability to meet product demand could be impaired or delayed.
We may not successfully manage our growth, which may result in delays or unanticipated difficulties in implementing our business plan.
Our success will depend upon the expansion of our operations and the effective management of our growth. We expect to experience growth in the scope of our operations and services and the number of our employees. If we grow significantly, such growth will place a significant strain on management and on administrative, operational and financial resources. To manage any growth, we may need to expand our facilities, augment our operational, financial and management systems, internal controls and infrastructure and hire and train additional qualified personnel. Our future success is heavily dependent upon growth and acceptance of our future products and services. If we are unable to scale our business appropriately or otherwise adapt to anticipated growth and new product introduction, our business, operating results, cash flows and financial condition may be harmed.
The medical imaging technology market is characterized by rapid technological change, frequent new product introductions and evolving industry standards, and we may encounter difficulties keeping pace with changes in this market.
The introduction of diagnostic tests embodying new technologies and the emergence of new industry standards can render existing tests obsolete and unmarketable in short periods of time. We expect competitors to introduce new products and services and enhancements to existing products and services. The life cycle of tests using the ACIS ® , and of the ACIS ® itself, are difficult to estimate. Our future success will depend upon our ability to enhance our current tests, to develop new tests, and to enhance and continue to develop the hardware and software included in the ACIS ® , in a manner that keeps pace with emerging industry standards and achieves market acceptance. Our inability to accomplish any of these endeavors will have a material adverse effect on our business, operating results, cash flows and financial condition.
We face substantial existing competition and potential new competition from others pursuing technologies for imaging systems.
We compete in a highly competitive industry. ACIS® was first released in 1997 for use in research as an imaging system for the detection of rare cellular events. The primary application was for the detection of cells which contained a marker used to distinguish possible cancerous cells in bone marrow. At that time, the most significant competition to the ACIS® for this application was use of manual microscopes and certain other cell-based techniques. These other techniques include PCR, a technique used in clinical labs to detect DNA sequences, and flow cytometry, a technique used to analyze biological material through the detection of the light-absorbing or fluorescing properties of cells. A natural progression for Clarient and the ACIS® was to penetrate the manually intensive slide-based cancer testing market, with an initial focus on the breast cancer market. Companies such as Dako, Ventana and BioGenex have greater cancer-testing market share and stronger medical laboratory relationships than we do. They also have two of the critical system components needed to drive standardizationreagents and staining automation. In July 2005, we entered into a distribution and development agreement with Dako relating to our ACIS® system, which is exclusive in research and clinical markets and non-exclusive with respect to biotechnology and pharmaceutical companies (and their academic research partners). Other imaging companies such as TriPath and Applied Imaging are currently expanding into this market. Advancements in alternative cancer diagnostic tests and the development of new protein-based therapies will bring increased competition to this market segment, and such competition could adversely affect our operating results, cash flows and financial condition. The clinical laboratory business is intensely competitive both in terms of price and service. This industry is dominated by several national independent laboratories, but includes many smaller niche and regional independent laboratories as well. Large commercial enterprises, including Quest and LabCorp, have substantially greater financial resources and may have larger research and development programs and more sales and marketing channels than we do, enabling them to potentially develop and market competing products and services. These enterprises
may also be able to achieve greater economies of scale or establish contracts with payer groups on more favorable terms. Smaller niche laboratories compete with us based on their reputation for offering a narrow test menu. Academic and regional medical institutions generally lack the advantages of the larger commercial laboratories but still compete with us on a limited basis. Pricing of laboratory testing services is one of the significant factors often used by health care providers in selecting a laboratory. As a result of the clinical laboratory industry undergoing significant consolidation, larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing. This consolidation results in greater price competition. We may be unable to increase cost efficiencies sufficiently, if at all, and as a result, our operating results, cash flows and our financial position could be negatively impacted by such price competition.
Competition in the pharmaceutical and biotechnology industries, and the medical devices and diagnostic products segments in particular, is intense and has been accentuated by the rapid pace of technological development. Our competitors in this area include large diagnostics and life sciences companies. Most of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing, sales and service resources than we do. Some of them also have more experience than we do in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales.
Because of their experience and greater research and development capabilities, our competitors might succeed in developing and commercializing technologies or products earlier and obtaining regulatory approvals and clearances from the FDA more rapidly than we can. Our competitors also might develop more effective technologies or products that are more predictive, more highly automated or more cost-effective, and that may render our technologies or products obsolete or non-competitive.
Failure in our information technology systems could disrupt our operations.
Our success will depend, in part, on the continued and uninterrupted performance of our information technology systems. Information systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our information technology systems.
Our computer systems are vulnerable to damage from a variety of sources, including telecommunications failures, malicious human acts and natural disasters. Moreover, despite reasonable security measures we have implemented, some of our information technology systems are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems, in part because we conduct business on the Internet and because some of these systems are located at third party web hosting providers and we cannot control the maintenance and operation of the data centers. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems, leading to lost revenue, deterioration of customer confidence, or significant business disruption. Our business, financial condition, results of operations, or cash flows could be materially and adversely affected by any problem that interrupts or delays our operations.
If a catastrophe were to strike our facility, we would be unable to operate our business competitively.
We currently assemble, test and release our ACIS® device and provide diagnostic services at our new laboratory facility in Aliso Viejo, California. We do not have alternative production plans in place or alternative facilities available at this time. If there are unforeseen shutdowns to our facility, we will be unable to satisfy customer orders on a timely basis.
Our facilities may be affected by catastrophes such as fires, earthquakes or sustained interruptions in electrical service. Earthquakes are of particular significance to us because all of our clinical laboratory facilities are located in Southern California, an earthquake-prone area. In the event our existing facilities or equipment are affected by man-made or natural disasters, we may be unable to process our customers samples in a timely manner and unable to operate our business in a commercially competitive manner.
We rely significantly on third-party manufacturers who may fail to supply us with components necessary to our products and services on a timely basis.
We rely currently and intend to continue to rely significantly in the future on third-party manufacturers to produce all of the components used in our ACIS® device, for future instrument systems that we may develop and for laboratory reagents and supplies. We are dependent on these third-party manufacturers to perform their obligations in a timely and effective manner and in compliance with FDA and other regulatory requirements.
To date, we have generally not experienced difficulties in obtaining components, reagents and supplies from our manufacturers and, in cases where a particular manufacturer was unable to provide us with a necessary component, we have been able to locate suitable secondary sources. However, if the suppliers we rely on in the manufacturing of our products were unable to supply us with necessary components, reagents and supplies, and we were unable to locate acceptable secondary sources, we might be unable to satisfy product demand, which would negatively impact our business. In addition, if any of these components are no longer available in the marketplace, we will be forced to further develop our technologies to incorporate alternate components. If we incorporate new components or raw materials into our products we might need to seek and obtain additional approvals or clearances from the FDA or foreign regulatory agencies, which could delay the commercialization of these products.
Our ability to maintain our competitive position depends on our ability to attract and retain highly qualified managerial, technical and sales and marketing personnel.
We believe that our continued success depends to a significant extent upon the efforts and abilities of our executive officers and our scientific and technical personnel, including the following individuals:
· Ronald A. Andrews, our President and Chief Executive Officer;
· James V. Agnello, our Senior Vice President and Chief Financial Officer;
· Heather Creran, our Executive Vice President and Chief Operating OfficerDiagnostic Services;
· Ken Bloom, M.D., our Chief Medical Director;
· Karen Garza, our Senior Vice President, Strategic Planning & Business Development
· Jose de la Torre-Bueno, Ph.D., our Vice President and Chief Technology Officer;
· David J. Daly, our Vice President of Sales; and
· James Cureton, our Vice President of Instrument Systems.
We do not maintain key-person life insurance on any of our officers, scientific and technical personnel or other employees. The loss of any of our executive officers or senior managers could have a material adverse effect on our business, operating results, cash flows and financial condition.
Furthermore, our anticipated growth and expansion will require the addition of highly skilled technical, management, financial, sales and marketing personnel. In particular, we may encounter difficulties in attracting a sufficient number of qualified California licensed laboratory scientists. Competition for personnel is intense, and our failure to hire and retain talented personnel or the loss of one or more key employees could have a material adverse effect on our business. Many members of our current senior management group have been recruited and hired over the past 18 months. These individuals may not be able to fulfill their responsibilities adequately and may not remain with us.
The reimbursement rate for ACIS®-based services has changed over the past several years and further changes may result in an adverse effect on our revenues and results of operations.
The majority of the sales of our products in the U.S. and other markets will depend, in large part, on the availability of adequate reimbursement to users of these products from government insurance plans, including Medicare and Medicaid in the U.S., managed care organizations, private insurance plans and other third-party payers. The continued success of the ACIS® depends upon its ability to replace or augment existing procedures that are covered and otherwise eligible for payments and covered by the medical insurance industry.
Laboratory services provided for patients with the assistance of ACIS® technology are eligible for third party reimbursement using medical billing codes which apply to image analysis-based testing. These billing codes are known as Healthcare Common Procedure Coding System (HCPCS) codes, which include the CPT codes as the means by which Medicare and private insurers identify medical services that are provided to patients in the United States. CPT codes are established by an independent editorial panel convened by the American Medical Association (AMA). The reimbursement amounts, or relative values, associated with the CPT codes are established by the Centers for Medicare and Medicaid Services (CMS), under a process that involves recommendations from an independent Relative Value Update Committee also convened by the AMA, with advice from professional societies representing the various medical specialties.
A new CPT code appropriate for image analysis went into effect on January 1, 2004. The interim rates established for this code in 2004 were subsequently amended on January 1, 2005. Under the new code, the total Medicare reimbursement for ACIS®-based procedures performed in physician offices or independent laboratories is approximately $168 per test, reflecting a technical component of approximately $100 and a professional component of approximately $68. The technical component involves preparation of the patient sample and running the test on the ACIS ®, while the professional component involves the physicians reading and evaluation of the test results. The actual amount varies based upon a geographic factor index for each state and may be higher or lower than the amounts indicated above in particular cases based on ones geographic location. In southern California, for example, where Clarients technical services are currently performed, the reimbursement amount for technical services is approximately $122 per slide.
We are not able to fully assess or predict the full impact of future changes in reimbursement levels on our business at this time, nor whether Medicare or other payers will review the medical necessity and appropriateness of amounts that have been paid in prior years, although it is likely that reductions in reimbursement levels will impact our pricing, profitability and the demand for testing.
Our net revenue will be diminished if payers do not adequately cover or reimburse our services.
There has been and will continue to be significant efforts by both federal and state agencies to reduce costs in government healthcare programs and otherwise implement government control of healthcare costs. In addition, increasing emphasis on managed care in the U.S. may continue to put pressure on the pricing of healthcare services. Uncertainty exists as to the coverage and reimbursement status of new applications or services. Third party payers, including governmental payers such as Medicare and private payers, are scrutinizing new medical products and services and may not cover or may limit coverage and change the level of
reimbursement for our services. Third party insurance coverage may not be available to patients for any of our existing assays or assays we discover and develop. However, a substantial portion of the testing for which we bill our hospital and laboratory clients is ultimately paid by third party payers. Any pricing pressure exerted by these third party payers on our customers may, in turn, be exerted by our customers on us. If government and other third party payers do not provide adequate coverage and reimbursement for our assays, our operating results, cash flows or financial condition may decline.
Managed care organizations are using discounted or capitated payment contracts in an attempt to shift payment risks which may negatively impact our operating margins.
Managed care providers typically contract with a limited number of clinical laboratories and then designate the laboratory or laboratories to be used for tests ordered by participating physicians. The majority of managed care testing is negotiated on a fee-for-service basis at a discount. Such discounts have historically resulted in price erosion and we expect that they could negatively impact our operating margins as we continue to offer laboratory services to managed care organizations.
Third party billing is extremely complicated and will result in significant additional costs to us.
Billing for laboratory services is extremely complicated. The customer refers the tests; the payer is the party that pays for the tests, and the two are not always the same. Depending on the billing arrangement and applicable law, we need to bill various payers, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of which have different billing requirements. Additionally, our billing relationships require us to undertake internal audits to evaluate compliance with applicable laws and regulations as well as internal compliance policies and procedures. Insurance companies also impose routine external audits to evaluate payments made. This adds further complexity to the billing process.
Among many other factors complicating billing are:
· pricing differences between our fee schedules and the reimbursement rates of the payers;
· shared responsibilities between payers and patients as to which party is responsible for discrete portions of payment; and
· disparity in coverage and information requirements among various carriers.
We incur significant additional costs as a result of our participation in the Medicare and Medicaid programs, as billing and reimbursement for clinical laboratory testing are subject to considerable and complex federal and state regulations. The additional costs we expect to incur include those related to: (1) complexity added to our billing processes; (2) training and education of our employees and customers; (3) implementing compliance procedures and oversight; (4) collections and legal costs; and (5) costs associated with, among other factors, challenging coverage and payment denials and providing patients with information regarding claims processing and services, such as advanced beneficiary notices.
Risks Related to Litigation and Intellectual Property
Product liability claims could subject us to significant monetary damage.
The manufacture and sale of the ACIS® and similar products entails an inherent risk of product liability arising from an inaccurate, or allegedly inaccurate, test or diagnosis. We currently maintain numerous insurance policies, including a $2 million general liability policy, a $5 million technology-based errors and omissions policy and a $10 million umbrella liability policy (which excludes technology based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions for medical malpractice and asbestos). Although we have not experienced any material losses to date, we cannot assure you that we will be able to maintain or acquire adequate product liability insurance in the future. Any product liability claim against us could have a material adverse effect on our reputation and operating results, cash flows and financial condition.
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.
The development, marketing, sale and performance of healthcare services expose us to the risk of litigation, including professional negligence. Damages assessed in connection with, and the costs of defending, any legal action could be substantial. We currently maintain numerous insurance policies, including a $3 million professional liability insurance policy ($2 million per incident). This policy has a deductible of $10,000 and contains customary exclusions (including exclusions relating to asbestos and biological contaminants). However, we may be faced with litigation claims which exceed our insurance coverage or are not covered under any of our insurance policies. In addition, litigation could have a material adverse effect on our business if it impacts our existing and potential customer relationships, creates adverse public relations, diverts management resources from the operation of the business or hampers our ability to perform assays or otherwise conduct our business.
If we use biological and hazardous materials in a manner that causes injury, we could be liable for damages.
Our research and development and clinical pathology activities sometimes involve the controlled use of potentially harmful biological materials, hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury to third parties from the use, storage, handling or disposal of these materials. We currently maintain
numerous insurance policies, including a $2 million general liability policy and a $10 million umbrella liability policy (which excludes technology-based errors and omissions). These policies have deductible ranges from $5,000 to $25,000 and contain customary exclusions (including certain exclusions relating to asbestos and medical malpractice). However, in the event of contamination or injury, we could be held liable for any resulting damages, and any liability could exceed our resources or any applicable insurance coverage we may have. Additionally, we are subject on an ongoing basis to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and could negatively affect our operations, cash flows and financial condition if these costs increase substantially.
Any breakdown in the protection of our proprietary technology, or any determination that our proprietary technology infringes on the rights of others, could materially affect our business.
Our commercial success will depend in part on our ability to protect and maintain our proprietary technology and to obtain and enforce patents on our technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. However, obtaining, defending and enforcing our patents and other intellectual property rights involve complex legal and factual questions. We cannot assure you that we will be able to obtain, defend or enforce our patent rights covering our technologies in the U.S. or in foreign countries, or be able to effectively maintain our technologies as unpatented trade secrets or otherwise obtain meaningful protection for our proprietary technology. Moreover, we cannot assure you that third parties will not infringe, design around, or improve upon our proprietary technology or rights.
The healthcare industry has been the subject of extensive litigation regarding patents and other proprietary rights and if we are unable to protect our patents and proprietary rights, through litigation or otherwise, our reputation and competitiveness in the marketplace could be materially damaged.
We may initiate litigation to attempt to stop the infringement of our patent claims or to attempt to force an unauthorized user of our trade secrets to compensate us for the infringement or unauthorized use. Patent and trade secret litigation is complex and often difficult and expensive, and would consume the time of our management and other significant resources. If the outcome of litigation is adverse to us, third parties may be able to use our technologies without payments to us. Moreover, some of our competitors may be better able to sustain the costs of litigation because they have substantially greater resources. Because of these factors relating to litigation, we may be unable to prevent misappropriation of our patent and other proprietary rights effectively.
If the use of our technologies conflicts with the intellectual property rights of third-parties, we may incur substantial liabilities and we may be unable to commercialize products based on these technologies in a profitable manner, if at all.
Our competitors or others may have or acquire patent rights that they could enforce against us. If they do so, we may be required to alter our technologies, pay licensing fees or cease activities. If our technologies conflict with patent rights of others, third parties could bring legal action against us or our licensees, suppliers, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products. If these legal actions are successful, in addition to any potential liability for damages, we might have to obtain a royalty or licensing arrangement in order to continue to manufacture or market the affected products. A required license or royalty under the related patent or other intellectual property may not be available on acceptable terms, if at all.
We may be unaware of issued patents that our technologies infringe. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, that may later result in issued patents upon which our technologies may infringe. There could also be existing patents of which we are unaware upon which our technologies may infringe. In addition, if third parties file patent applications or obtain patents claiming technology also claimed by us in pending applications, we may have to participate in interference proceedings in the U.S. Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of the filed foreign patent applications. We may have to participate in interference proceedings involving our issued patents or our pending applications.
If a third party claims that we infringe upon its proprietary rights, any of the following may occur:
· we may become involved in time-consuming and expensive litigation, even if the claim is without merit;
· we may become liable for substantial damages for past infringement, including possible treble damages for allegations of willful infringement, if a court decides that our technologies infringe upon a competitors patent;
· a court may prohibit us from selling or licensing our product without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross licenses to our patents; and
· we may have to redesign our product so that it does not infringe upon others patent rights, which may not be possible or could require substantial funds or time.
If any of these events occurs, our business, results of operation, cash flows and financial condition will suffer and the market price of our common stock will likely decline.
Risks Related to Regulation of Our Industry
FDA regulations and those of other regulatory agencies can cause significant uncertainty, delay and expense in introducing new applications for the ACIS® and present a continuing risk to our ability to offer applications.
As a medical device, our ACIS® product is subject to extensive and frequently changing federal, state and local governmental regulation in the U.S. and in other countries. The FDA pursuant to its authority under the Food, Drug and Cosmetic Act, regulates virtually all aspects of the development, testing, manufacture, labeling, storage, record keeping, distribution, sale, marketing, advertising and promotion and importing and exporting of medical devices. Failure to comply with applicable governmental requirements can result in fines, recall or seizure of products, total or partial suspension of production, withdrawal of existing product approvals or clearances, refusal to approve or clear new applications or notices and criminal prosecution. In addition, changes in existing laws or regulations, or new laws or regulations, may delay or prevent us from marketing our products or cause us to reduce our pricing.
If we are not able to obtain all of the regulatory approvals and clearances required to commercialize our products, our business would be significantly harmed.
The ACIS® and other medical devices we develop require clearance or approval by the FDA before they can be commercially distributed in the U.S. and may require similar approvals by foreign regulatory authorities before distribution in foreign jurisdictions. Regulatory clearance or approval of applications for the ACIS® or other products we may develop, including the related software, may be denied or may include significant limitations on the indicated uses for which it may be marketed. The FDA actively enforces the prohibition on marketing products that have not been approved or cleared and also imposes and enforces strict regulations regarding the validation and quality of manufacturing, which are enforced through periodic inspection of manufacturing facilities. Foreign countries have comparable regulations.
In most cases, the development and commercialization of additional diagnostic applications in the U.S. will require either pre-market notification, or 510(k) clearance, or pre-market approval (PMA) from the FDA prior to marketing. The 510(k) clearance pathway usually takes from two to twelve months from submission, but can take longer. The pre-market approval pathway is much more costly, lengthy, uncertain and generally takes from one to two years or longer from submission. We do not know whether we will be able to obtain the clearances or approvals required to commercialize these products. In addition, modifications and enhancements to a medical device also require a new FDA clearance or approval if they could significantly affect its safety or effectiveness or would constitute a major change in the devices intended use, design or manufacture. The FDA requires every manufacturer to make this determination in the first instance, but the FDA may review any manufacturers decision. If the FDA requires us to seek clearance or approval for modification of a previously cleared product for which we have concluded that new clearances or approvals are unnecessary, we may be required to cease marketing or to recall the modified product until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties.
In the case of a PMA and/or a 510(k), there is no assurance that the agency will agree with the submission and/or clear or approve the product. FDA may reject a 510(k) submission and require that a company file a PMA instead. Determination by FDA that any of our devices or certain applications of ours are subject to the PMA process could have a material adverse effect on our business, results of operations and financial condition. Nonetheless, a business benefit can accrue where FDA approves a PMA because holding a PMA may, in some instances, provide a competitive advantage. A change or modification of a medical device that has already received FDA clearance or approval can result in the need to submit further filings to the agency.
Applications submitted for FDA clearance or approval will be subject to substantial restrictions, including, among other things, restrictions on the indications for which we may market these products, which could result in lower revenues. The marketing claims we will be permitted to make in labeling or advertising regarding our cancer diagnostic products, if cleared or approved by the FDA, will be limited to those specified in any clearance or approval. In addition, we are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. Finally, we are subject to medical device reporting regulations that require us to report to the FDA or similar governmental bodies in other countries if our products cause or contribute to a death or serious injury or malfunction in a way that would be reasonably likely to contribute to death or serious injury if the malfunction were to recur. If the FDA finds that we have failed to comply with these requirements, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:
· fines, injunctions and civil penalties;
· recall or seizure of our products;
· operating restrictions, partial suspension or total shutdown of production;
· denial of requests for 510(k) clearances or pre-market approvals of product candidates;
· withdrawal of 510(k) clearances or pre-market approvals already granted; and
· criminal prosecution.
Any of these enforcement actions could affect our ability to commercially distribute our products in the U.S. and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of additional applications.
We cannot predict the extent of future FDA regulation of our in-house diagnostic laboratory services.
Neither the FDA nor any other governmental agency currently fully regulates the in-house diagnostic laboratory services that we market to physicians, laboratory professionals and other medical practitioners. These tests are commonly referred to as home brews. FDA maintains that it has the authority to regulate home brews under the Federal Food, Drug, and Cosmetic Act as medical devices, however, as a matter of enforcement discretion, but has decided not to exercise its authority. FDA is currently assessing the feasibility of applying additional regulatory controls over in-house diagnostic laboratory testing. We cannot predict the extent of future FDA regulation and there can be no assurance that the FDA will not require in-house diagnostic laboratory testing to receive premarketing clearance, or premarket approval prior to marketing. Additional FDA regulatory controls over our in-house diagnostic laboratory services could add substantial additional costs to our operations, and may delay or prevent our ability to commercially distribute our services in the U.S.
Our medical devices, facilities and products are subject to significant quality control oversight and regulations, and our failure to comply with these could result in penalties or enforcement proceedings.
Manufacturers of medical devices are subject to federal and state regulation regarding validation and the quality of manufacturing facilities, including FDAs Quality System Regulation, or QSR, which covers, among other things, the design, testing production processes, controls, quality assurance, labeling, packaging, storing and shipping of medical devices. The FDA periodically inspects facilities to ascertain compliance with these and other requirements. Our failure to comply with these quality system regulations could result in, among other things, warning letters, fines, injunctions, seizures, civil or criminal penalties or enforcement proceedings, including the recall of a product or a cease distribution order requiring us to stop placing our products in service or selling, any one of which could materially adversely affect our business, results of operations and financial condition. Similar results would occur if we were to violate foreign regulations.
Our operations are subject to strict laws prohibiting fraudulent billing and other abuse, and our failure to comply with such laws could result in substantial penalties.
Of particular importance to our operations are federal and state laws prohibiting fraudulent billing and providing for the recovery of non-fraudulent overpayments, as a large number of laboratories have been forced by the federal and state governments, as well as by private payers, to enter into substantial settlements under these laws. In particular, if an entity is determined to have violated the federal False Claims Act, it may be required to pay up to three times the actual damages sustained by the government, plus civil penalties of between $5,500 to $11,000 for each separate false claim. There are many potential bases for liability under the federal False Claims Act. Liability arises, primarily, when an entity knowingly submits, or causes another to submit, a false claim for reimbursement to the federal government. Submitting a claim with reckless disregard or deliberate ignorance of its truth or falsity could result in substantial civil liability. A trend affecting the healthcare industry is the increased use of the federal False Claims Act and, in particular, actions under the False Claims Acts whistleblower or qui tam provisions. Those provisions allow a private individual to bring actions on behalf of the government alleging that the defendant has submitted a fraudulent claim for payment to the federal government. The government must decide whether to intervene in the lawsuit and to become the primary prosecutor. If it declines to do so, the individual may choose to pursue the case alone, although the government must be kept apprised of the progress of the lawsuit. Whether or not the federal government intervenes in the case, it will receive the majority of any recovery. In recent years, the number of suits brought against healthcare providers by private individuals has increased dramatically. In addition, various states have enacted laws modeled after the federal False Claims Act.
Government investigations of clinical laboratories have been ongoing for a number of years and are expected to continue in the future. Written corporate compliance programs to actively monitor compliance with fraud laws and other regulatory requirements are recommended by the Department of Health and Human Services Office of the Inspector General and we have a program following the guidelines in place.
Our laboratory services are subject to extensive federal and state regulation, and our failure to comply with such regulations could result in penalties or suspension of Medicare payments and/or loss of our licenses, certificates or accreditation.
The clinical laboratory testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. The CLIA and implementing regulations established quality standards for all laboratory testing to ensure the accuracy, reliability and timeliness of patient test results regardless of where the test was performed. Laboratories covered under CLIA are those which perform laboratory testing on specimens derived from humans for the purpose of providing information for the diagnosis, prevention, treatment of disease and other factors. The Centers for Medicare and Medicaid Services is charged with the implementation of CLIA, including registration, surveys, enforcement and approvals of the use of private accreditation agencies. For certification under CLIA, laboratories such as ours must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Since we perform patient testing from all states, our laboratory is also subject to strict regulation by California, New York and various other states. State laws require that laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records, and are required to possess state regulatory licenses to offer the professional and technical components of laboratory services. If we are unable to maintain our existing state regulatory licenses in a timely manner or if we are unable to secure new state regulatory licenses for new locations, our ability to provide laboratory services could be compromised. Our failure to comply with CLIA, state or other applicable requirements could result in various penalties, including restrictions on tests which the laboratory may perform, substantial civil monetary penalties, imposition of specific corrective action plans, suspension of Medicare payments and/or loss of licensure, certification or accreditation. Such penalties could result in our being unable to continue performing laboratory testing. Compliance with such standards is verified
by periodic inspections and requires participation in proficiency testing programs.
We are subject to significant environmental, health and safety regulation.
We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the federally-enacted Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.
We are subject to federal and state laws governing the financial relationship among healthcare providers, including Medicare and Medicaid laws, and our failure to comply with these laws could result in significant penalties and other adverse consequences.
Existing federal laws governing Medicare and Medicaid and other similar state laws impose a variety of broadly described restrictions on financial relationships among healthcare providers, including clinical laboratories. These laws include the federal anti-kickback law which prohibits individuals or entities, including clinical laboratories, from, among other things, making any payments or furnishing other benefits intended to induce or influence the referral of patients for tests billed to Medicare, Medicaid or certain other federally funded programs. Several courts have interpreted the statutes intent requirement to mean that if any one purpose of an arrangement involving remuneration is to induce referrals of federal healthcare covered business, the statute has been violated. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. In addition, some kickback allegations have been claimed to violate the federal False Claims Act (discussed above). In addition, many states have adopted laws similar to the federal anti-kickback law. Some of these state prohibitions apply to referral of patients for healthcare items or services reimbursed by any source, not only the Medicare and Medicaid programs. Many of the federal and state anti-fraud statutes and regulations, including their application to joint ventures and collaborative agreements, are vague or indefinite and have not been interpreted by the courts.
In addition, these laws also include self-referral prohibitions which prevent us from accepting referrals from physicians who have non-exempt ownership or compensation relationships with us as well as anti-markup and direct billing rules that may apply to our relationships with our customers. Specifically, the federal anti-self-referral law, commonly known as the Stark Law, prohibits, with certain exceptions, Medicare payments for laboratory tests referred by physicians who have, personally or through a family member, an investment interest in, or a compensation arrangement with, the testing laboratory. A person who engages in a scheme to circumvent the Stark Laws prohibitions may be fined up to $100,000 for each such arrangement or scheme. In addition, anyone who presents or causes to be presented a claim to the Medicare program in violation of the Stark Law is subject to monetary penalties of up to $15,000 per claim submitted, an assessment of several times the amount claimed, and possible exclusion from participation in federal healthcare programs. In addition, claims submitted in violation of the Stark Law may be alleged to be subject to liability under the federal False Claims Act and its whistleblower provisions. Several states in which we operate have enacted legislation that prohibits physician self-referral arrangements and/or requires physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Some of these statutes cover all patients and are not limited to Medicare or Medicaid beneficiaries. Possible sanctions for violating state physician self-referral laws vary, but may include loss of license and civil and criminal sanctions. State laws vary from jurisdiction to jurisdiction and, in a few states, are more restrictive than the federal Stark Law. Some states have indicated they will interpret their own self-referral statutes the same way that the U.S. Centers for Medicare and Medicaid Services (CMS) interprets the Stark Law, but it is possible the states will interpret their own laws differently in the future. The laws of many states prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to practice medicine.
If we do not comply with existing or additional regulations, or if we incur penalties, it could increase our expenses, prevent us from increasing net revenue, or hinder our ability to conduct our business. In addition, changes in existing regulations or new regulations may delay or prevent us from marketing our products or cause us to reduce our pricing.
Our business is subject to stringent laws and regulations governing the privacy, security and transmission of medical information, and our failure to comply could subject us to criminal penalties and civil sanctions.
The use and disclosure of patient medical information is subject to substantial regulation by federal, state, and foreign governments. For example, the Health Insurance Portability and Accountability Act of 1996, known as HIPAA, was enacted among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and privacy of individually identifiable health information maintained or transmitted by health care providers, health plans and health care clearinghouses. We are currently required to comply with three standards under HIPAA. We must comply with the Standards for Electronic Transactions, which establish standards for common health care transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures; unique identifiers for providers, employers, health plans and individuals; security; privacy; and enforcement. We were required to comply with these Standards by October 16, 2003. We also must
comply with the Standards for Privacy of Individually Identifiable Information, which restrict our use and disclosure of certain individually identifiable health information. We were required to comply with the Privacy Standards by April 14, 2003. The Security Standards required us to implement certain security measures to safeguard certain electronic health information by April 20, 2005. In addition, CMS has published a final rule, which will require us to adopt a Unique Health Identifier for use in filing and processing health care claims and other transactions by May 23, 2007. While the government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us. If we fail to comply with these standards, we could be subject to criminal penalties and civil sanctions.
The Standards for Privacy of Individually Identifiable Information establish a floor and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws. In addition, for health care data transfers from other countries relating to citizens of those countries, we must comply with the laws of those other countries.
Federal law and the laws of many states generally specify who may practice medicine and limit the scope of relationships between medical practitioners and other parties.
Under such laws, we are prohibited from practicing medicine or exercising control over the provision of medical services and may only do so through a professional corporation designed for this purpose. In order to comply with such laws, all medical services are provided by or under the supervision of Clarient Pathology Associates, Inc. (the P.C.). We refer to the P.C. and us collectively throughout this report as we, us, and our, except in this paragraph. The P.C. is organized so that all physician services are offered by the physicians who are employed by the P.C. Clarient does not employ practicing physicians as practitioners, exert control over their decisions regarding medical care, or represent to the public that Clarient offers medical services. Clarient has entered into an Administrative Services Agreement with the P.C. pursuant to which Clarient performs all non-medical management of the P.C. and has exclusive authority over all aspects of the business of the P.C. (other than those directly related to the provision of patient medical services or as otherwise prohibited by state law). The non-medical management provided by Clarient includes, among other functions, treasury and capital planning, financial reporting and accounting, pricing decisions, patient acceptance policies, setting office hours, contracting with third party payers, and all administrative services. Clarient provides all of the resources (systems, procedures, and staffing) or contract with third party billing services to bill third party payers or patients. Clarient also provides or outsources all of the resources for cash collection and management of accounts receivables, including custody of the lockbox where cash receipts are deposited. From the cash receipts, Clarient pays all physician salaries and operating costs of the center and of Clarient. Compensation guidelines for the licensed medical professionals at the P.C. are set by Clarient, and Clarient has established guidelines for selecting, hiring, and terminating the licensed medical professionals. Where applicable, Clarient also negotiates and execute substantially all of the provider contracts with third party payers. Clarient will not loan or otherwise advance funds to the P.C. for any purpose.
Clarient believes that the services Clarient provides and will provide in the future to the P.C. does not constitute the practice of medicine under applicable laws. Because of the unique structure of the relationships described above, many aspects of our business operations have not been the subject of state or federal regulatory interpretation. We have no assurance that a review of our business by the courts or regulatory authorities will not result in a determination that could adversely affect our operations or that the health care regulatory environment will not change so as to restrict our existing operations or future expansion.
Risks Related to Our Common Stock
We have never paid cash dividends on our common stock and do not anticipate paying dividends on our common stock, which may cause you to rely on capital appreciation for a return on your investment.
We currently intend to retain future earnings for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Accordingly, you will have to rely on capital appreciation, if any, to earn a return on your investment in our common stock.
If we raise additional funds you may suffer dilution or subordination and we may grant rights in our technology or products to third parties.
If we raise additional funds by issuing equity securities, further dilution to our stockholders could result, and new investors could have rights superior to those of holders of the shares of our common stock. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we may have to delay or may be unable to continue to develop our products.
Our stock price is likely to continue to be volatile, which could result in substantial losses for investors
The market price of our common stock has in the past been, and in the future is likely to be, highly volatile. These fluctuations could result in substantial losses for investors. Our stock price may fluctuate for a number of reasons including, but not limited to:
· media reports and publications and announcements about cancer or diagnostic products or treatments or new innovations;
· developments in or disputes regarding patent or other proprietary rights;
· announcements regarding clinical trials or other technological or competitive developments by us and our competitors;
· loss of a significant customer or group purchasing organization contract;
· the hiring and retention of key personnel;
· announcements concerning our competitors or the biotechnology industry in general;
· regulatory developments regarding us or our competitors;
· changes in reimbursement policies concerning our products or competitors products;
· changes in the current structure of the healthcare financing and payment systems;
· stock market price and volume fluctuations, which have particularly affected the market prices for medical products and high technology companies and which have often been unrelated to the operating performance of such companies; and
· general economic, political and market conditions.
In addition, stock markets have from time to time experienced extreme price and volume fluctuations. The market prices for medical device and laboratory service affected by these market fluctuations and such effects have often been unrelated to the operating performance of such companies. These broad market fluctuations may cause a decline in the market price of our common stock.
Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. This type of litigation could be brought against us in the future, which could result in substantial expense and damage awards and divert managements attention from running our business.
With the advent of the Internet, new avenues have been created for the dissemination of information. We do not have control over the information that is distributed and discussed on electronic bulletin boards and investment chat rooms. The motives of the people or organizations that distribute such information may not be in our best interest or in the interest of our shareholders. This, in addition to other forms of investment information, including newsletters and research publications, could result in a significant decline in the market price of our common stock.
Future sales of shares by existing stockholders could result in a decline in the market price of the stock.
Some of our current stockholders hold a substantial number of shares which they are currently able to sell in the public market, or which they will be able to sell under registration statements that have already been declared effective by the Securities and Exchange Commission, and our employees hold options to purchase a significant number of shares and/or have been issued shares of restricted stock that are covered by registration statements on Form S-8. If our common stockholders sell substantial amounts of common stock in the public market, or the market perceives that such sales may occur, the market price of our common stock could fall. Safeguard, which owns a majority of our outstanding common stock, has rights, subject to some conditions, to require us to file registration statements covering shares owned by them that are not already covered by existing registration statements and to include Safeguards shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we were to include in a Company-initiated registration statement shares held by Safeguard pursuant to the exercise of its registrations rights, the sale of those shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.
We are controlled by a single existing stockholder, whose interests may differ from other stockholders interests and may adversely affect the trading price of our common stock.
Safeguard beneficially owns a majority of the outstanding shares of our common stock. As a result, Safeguard will have significant influence in determining the outcome of any corporate transaction or other matter submitted to the stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets. In addition, Safeguard has the ability to elect all of our directors (although Safeguard has contractually agreed with us that our board of directors will consist of a majority of directors not specifically designated by Safeguard) and Safeguard could dictate the management of our business and affairs. The interests of Safeguard may differ from other stockholders interests. In addition, this concentration of ownership may delay, prevent, or deter a change in control and could deprive other stockholders of an opportunity to receive a premium for their common stock as part of a sale of our business. This significant concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.
We have adopted a stockholder rights plan and other arrangements which could inhibit a change in control and prevent a stockholder from receiving a favorable price for his or her shares.
Our board of directors has adopted a stockholders rights plan providing for discounted purchase rights to its stockholders upon specified acquisitions of our common stock. The exercise of these rights is intended to inhibit specific changes of control of our company.
In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by our board of directors. These provisions and others could make it difficult for a third party to acquire us, or for members of our board of directors to be replaced, even if doing so would be beneficial to our stockholders. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace the current management team. If a change of control or change in management is delayed or prevented, you may lose an opportunity to realize a premium on your shares of common stock or the market price of our common stock could decline.
Our shares of common stock currently trade on the Nasdaq Capital Market which results in a number of legal and other consequences that may negatively affect our business and the liquidity and price of our common stock.
With our securities listed on the Nasdaq Capital Market, we face a variety of legal and other consequences that may negatively affect our business including, without limitation, the following:
· future issuances of our securities may require time-consuming and costly registration statements and qualifications because state securities law exemptions available to us are more limited;
· securities analysts may not initiate coverage of Clarient; and
· we may lose current or potential investors.
We are required to satisfy various listing maintenance standards for our common stock to be quoted on the Nasdaq Capital Market. If we fail to meet such standards, our common stock would likely be delisted from the Nasdaq Capital Market and trade on the over-the-counter bulletin board, commonly referred to as the pink sheets. This alternative is generally considered to be a less efficient market and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business, results of operations, cash flows and financial position.
We have received a notice of delisting from the Nasdaq Capital Market for failure to comply with Nasdaqs minimum bid price requirement and our shares may be delisted if we are unable to regain compliance with Nasdaq rules within the applicable grace periods.
On July 10, 2006 we received a notice from the Nasdaq Listing Qualification Staff (Staff) that our common stock is subject to delisting from the Nasdaq Capital Market as a result of failure to comply with the $1.00 per share bid price requirement for 30 consecutive days as required by Nasdaq Marketplace Rule 4310(c)(4) (the Rule). In accordance with Nasdaq Marketplace Rule 4310(c)(8)(D), we will be provided 180 calendar days, or until January 8, 2007, to regain compliance. If at anytime before January 8, 2007, the bid price of our common stock closes at $1.00 per share for 10 consecutive days, the Nasdaq staff will provide written notification that we comply with the Rule. If compliance with this Rule cannot be demonstrated by January 8, 2007, the Nasdaq staff will determine whether we meet The Nasdaq Capital Market initial listing criteria as set forth in Marketplace Rule 4310(c), except for the minimum bid price requirement. If it meets the other initial listing criteria, the Nasdaq staff will notify us that we have been granted another 180 calendar day compliance period. If we do not regain compliance with the Rule and are not eligible for an additional compliance period, the Staff will provide written notification that we will be delisted and, at that time, we may appeal the determination to delist to a Listing Qualifications Panel. As of the date of this filing, the Company has not received notification from Nasdaq that the Company has regained compliance.
Recently enacted and proposed changes in securities laws and regulations will increase our costs.
The Sarbanes-Oxley Act of