Clarient 10-Q 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the Transition Period from to
Commission File Number 000-22677
(Exact name of registrant as specified in its charter)
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 July 31, 2007, 71,719,814 shares of the Registrants common stock were outstanding.
CLARIENT, INC. AND SUBSIDIARIES
Table of Contents
CLARIENT, INC. AND SUBSIDIARIES
(in thousands, except share and per share amounts)
See accompanying notes to condensed consolidated financial statements.
CLARIENT, INC. AND SUBSIDIARIES
(in thousands, except share and per share amounts)
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) Basis of Presentation and Liquidity
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, 2006 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 financial statements have been prepared on a going concern basis which assumes that the Company will have sufficient resources to pay its obligations as they become due during at least the next 12 months. In addition to revenues from the Companys laboratory services business and cash proceeds from the sale of its instrument systems business, at June 30, 2007, the Company had $8.2 million of aggregate availability under its credit facilities with GE Capital and Safeguard, which may be used for working capital purposes. Management believes that its current cash resources and commitments under its credit facilities will enable the Company to maintain operations through at least the next 12 months. However, the Company has a history of operating losses and negative cash flows from operations, and future profitability is uncertain. If the Company is unable to achieve positive cash flow, it may fail to comply with one or more of its debt covenants, which, if not waived, may accelerate outstanding indebtedness. Additionally, if the Company is unable to access one or more of these financing sources, or if it encounters other difficulties in executing its business plan, it may require additional financing. There can be no assurance that the Company will be able to obtain additional debt or equity financing when needed or on terms that are favorable to the Company and its stockholders.
(2) Discontinued Operations
On March 8, 2007, the Company sold its instrument systems business, consisting of certain tangible assets, inventory, intellectual property (including the Companys patent portfolio and the ACIS and Chromavision trademarks), contracts and other assets used in the operations of the instrument systems business (the Technology business) to Carl Zeiss MicroImaging, Inc. and one of its subsidiaries (collectively, Zeiss) for an aggregate purchase price of $12.5 million, consisting of $11.0 million in cash and up to an additional $1.5 million in contingent purchase price which is payable in whole or in part (if at all) subject to satisfaction of certain post-closing conditions relating to intellectual property (the ACIS Sale). As part of the transaction, the Company entered into a license agreement with Zeiss pursuant to which Zeiss granted the Company a non-exclusive, perpetual and royalty-free license to certain of the transferred patents, copyrights and software code for use in connection with imaging applications (excluding sales of imaging instruments) and the Companys laboratory services business. The acquisition agreement also contemplates that the Company and Zeiss will each invest up to $3 million in cash or other in-kind contributions to pursue a joint development arrangement with respect to rare event detection. The acquisition agreement contemplated that the parties would cooperate to enter into a definitive agreement with respect to such an arrangement within 120 days following the closing date. The parties are currently engaged in discussions and have agreed to extend such target completion date to October 31, 2007. The Company has no obligation to invest any cash or other in-kind contributions should the parties be unable to agree upon terms for such a definitive agreement.
The assets transferred to Zeiss in the transaction included tangible assets, inventory, intellectual property (including the Companys patent portfolio and the ACIS and Chromavision trademarks), contracts (including the Companys distribution agreement with Dako), certain accounts receivable and other assets primarily used in the operation of the Technology business. Zeiss also assumed certain liabilities in connection with the transaction, including liabilities under transferred contracts, certain accounts payable, certain product maintenance and service obligations and certain other obligations relating to the Companys Technology business. The Company made customary representations and warranties to Zeiss in the definitive acquisition agreement and agreed to indemnify Zeiss with respect to any breaches thereof, subject to certain limitations. The Company also agreed to indemnify Zeiss with respect to liabilities not assumed by Zeiss, and Zeiss agreed to indemnify the Company with respect to liabilities assumed by it as well as liabilities arising out of the operation of the Technology business following the closing date.
The Company also agreed not to compete with Zeiss in connection with the development, production and sale of imaging instruments for a period of 42 months following the closing date. In addition, the Company agreed to provide certain customary transition services to Zeiss until September 2007 (subject to payment of customary transition services fees). The parties also entered into a sublease pursuant to which Zeiss will sublease the premises currently occupied by the Technology business for a period of three years following the closing date for a proportionate share of the rent payable to the landlord under the Companys lease agreement. Approximately 37 of the Companys employees that were devoted primarily to its Technology business were terminated on March 8, 2007 and were offered employment with Zeiss. The Company has agreed not to solicit those employees for employment without Zeisss consent for a period of 42 months following the closing date (unless such employees are first terminated by Zeiss). Zeiss did not hire any of the Companys executive officers.
The Technology business is reported in discontinued operations for all periods presented. The Company recognized a gain on sale which is calculated as follows (in thousands):
Results of discontinued operations were as follows (in thousands):
The assets and liabilities of the discontinued operations were as follows (in thousands):
(3) Equity-Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)). SFAS 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 123(R) also requires measurement of the cost of employee services received in exchange for an award.
Stock-based compensation related to continuing operations was as follows (in thousands):
The Companys 1996 Stock Option Plan expired on December 11, 2006. No options were granted during the six months ended June 30, 2007. At the Companys annual meeting on June 27, 2007, the stockholders voted in favor to approve the Companys 2007 Incentive Award Plan (the 2007 Plan). The 2007 Plan provides for the grant of incentive stock options and nonqualified stock options, restricted stock, stock appreciation rights, performance shares, performance stock units, dividend equivalents, stock payments, deferred stock, restricted stock units, performance bonus awards and performance-based awards. The maximum numbers of shares of common stock of the Company available for issuance under the 2007 Plan is the sum of 4,000,000 shares plus any shares which are subject to issuance under the Companys 1996 Stock Option Plan.
(4) Net Income (Loss) Per Share
Basic and diluted income (loss) per common share is calculated by dividing net income (loss) by the weighted average common shares outstanding during the period. Stock options, restricted stock and warrants to purchase an aggregate of 12,430,423 and 13,381,257 shares of common stock were outstanding at June 30, 2007 and 2006, respectively. Common stock equivalents were not included in the computation of diluted earnings per share for either the three months or six months ended June 30, 2007 and 2006, respectively, because the Company incurred a net loss from continuing operations in all periods presented and hence, the impact would be anti-dilutive.
(5) Comprehensive Income (Loss)
The total comprehensive loss is summarized as follows (in thousands):
(6) Business Segment
The Company operates primarily in one business segment engaged in the delivery of critical oncology testing services to community pathologists, biopharmaceutical companies and other researchers.
(7) Recent Accounting Developments,
In February 2007, FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Early adoption is permitted subject to specific requirements outlined in SFAS No. 159, which allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value that are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that items fair value in subsequent reporting periods must be recognized in current earnings. SFAS No. 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. Management is currently evaluating the effect of this pronouncement on financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This pronouncement is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48, effective January 1, 2007. The adoption of FIN 48 did not have a material impact on the Companys financial position, results of operations or cash flows. See Note 12.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No. 157). This statement provides a single definition of fair value, a framework for measuring fair value, and expanded disclosures concerning fair value. Previously, different definitions of fair value were contained in various accounting pronouncements creating inconsistencies in measurement and disclosures. SFAS No. 157 applies under those previously issued pronouncements that prescribe fair value as the relevant measure of value, except SFAS No. 123(R) and related interpretations and pronouncements that require or permit measurement similar to fair value but are not intended to measure fair value. This pronouncement is effective for fiscal years beginning after November 15, 2007. The Company does not expect the adoption of SFAS No. 157 to have a material impact on its financial position, results of operations or cash flows.
(8) Stock Transactions
Due to its beneficial ownership of approximately 60% of the Companys outstanding common stock, Safeguard Scientifics, Inc., (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.
(9) Lines of Credit
Comerica Line of Credit. In January 2007, the Company entered into an amendment to its revolving credit agreement with Comerica to increase available borrowings from $8.5 million to $12.0 million (consisting of a $9.0 million revolving line of credit and a $3.0 million stand-by letter of credit that has been provided to the landlord of the Companys headquarters and laboratory). The Comerica line of credit bears interest at a rate of Comericas prime rate minus 0.5%. In connection with the execution of the January 2007 amendment, the Company and Safeguard signed an Amended and Restated Reimbursement and Indemnity Agreement (the Reimbursement Agreement) under which Safeguard agreed to increase the amount of its guaranty to $12.3 million, which includes $0.3 million to cover any interest costs or fees that may be payable to Comerica. As consideration for Safeguards increase in its guaranty, the Company issued Safeguard, as a commitment fee, a four year warrant to purchase 100,000 shares of the Companys common stock for an exercise price of $0.01 per share (the Commitment Fee Warrant). In addition, the Company agreed to pay Safeguard a facility maintenance fee in the form of a four year warrant to purchase 166,667 shares of the Companys common stock for an exercise price of $1.64 per share (the Maintenance Fee Warrant). The Company recorded $337,000 of interest expense related to these warrants which is the full fair value of the warrants determined under the Black-Scholes option pricing model. The full fair value of the warrants was expensed in the quarter ended March 31, 2007, since, at the time the warrants were issued, the line of credit was to expire within the same quarter. Under the Reimbursement Agreement, the Company is required to pay Safeguard a quarterly usage fee of 1.125% of the daily weighted average principal balance ($9.0 million at June 30, 2007) outstanding under the Comerica revolving line of credit, plus .875% of the amount by which the daily average principal balance outstanding under the Comerica revolving line of credit exceeds $5.5 million. The usage fees expensed for the three months and six months ended June 30, 2007 were $133,000 and $243,000, respectively, and are included under interest expense to related parties. On February 28, 2007, the Company entered into an amendment to the Comerica loan agreement to extend the maturity date of the facility to February 27, 2008. The Company also obtained waivers from Comerica of the Companys failure to comply with the minimum tangible net worth covenant for periods prior to March 2007. In March 2007, the financial covenant relating to tangible net worth in the Comerica loan agreement was amended to provide that the Company must maintain tangible net worth of not less than $0.6 million through September 29, 2007 (with further reductions to negative $500,000 through December 30, 2007 and to negative $1.1 million at December 31, 2007 and for monthly periods thereafter). The Company obtained a waiver from Comerica of the Companys failure to comply with the revised tangible net worth covenant as of May 31, 2007, and the Company was in compliance with all financial covenants as of June 30, 2007. The Comerica line of credit includes an annual facility fee of $27,500. At June 30, 2007, the Company had borrowings of $9.0 million outstanding, a stand-by letter of credit of $3.0 million outstanding and had no availability under the line of credit.
GE Capital 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. 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 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. In January, February and March 2007, the Company entered into amendments to its Loan and Security Agreement with GE Capital, pursuant to which GE Capital consented to the increase in available borrowings under the Comerica Loan Agreement, the execution of the Reimbursement Agreement with Safeguard, the execution and incurrence of indebtedness under the Safeguard Mezzanine Facility (described below), and the sale of the Companys instrument systems business to Zeiss. In addition, in February 2007, the Company obtained waivers from GE Capital of its failure to comply with the minimum tangible net worth and minimum liquidity covenants in the GE Capital credit agreement. The March 2007 amendment modified the terms of the financial covenant requiring the Company to maintain a minimum level of tangible net worth, which is required to be not less than $0.6 million through September 29, 2007 (with further reductions to negative $500,000 through December 30, 2007 and to negative $1.1 million at December 31, 2007 and for monthly periods thereafter). The Company obtained a waiver from GE Capital of the Companys failure to comply with the revised tangible net worth covenant as of May 31, 2007, and the Company was in compliance with all financial covenants as of June 30, 2007. The GE Capital credit agreement also includes a financial covenant requiring the Company to maintain a minimum fixed charge coverage ratio of 1.00 to 1.00, or a minimum liquidity requirement of three months cash burn (defined as balance sheet cash plus excess borrowing base available under the credit agreement). At June 30, 2007, the Company had $1.3 million outstanding under this $5.0 million facility. Based on the amount of the Companys qualified accounts receivable at June 30, 2007, the Company estimated it had $2.2 million available under the line of credit.
Safeguard Mezzanine Financing. On March 7, 2007, the Company obtained a subordinated revolving credit line (the Mezzanine Facility) from a Safeguard affiliate. The Mezzanine Facility, which expires December 8, 2008, provides the Company access to up to $6.0 million in working capital funding as the Company continues to grow its business. Borrowings on the Mezzanine Facility will bear interest at an annual rate of 12%. The Mezzanine Facility was originally $12.0 million, but was reduced by $6.0 million as a result of the ACIS Sale. In connection with the Mezzanine Facility, the Company issued (or is required to issue) to Safeguard: (1) warrants to purchase 125,000 shares of common stock with an exercise price of $0.01 per share, expiring March 7, 2011; (2) warrants to purchase 62,500 shares of common stock with an exercise price of $1.39 per share (reflecting a 15% discount to the trailing 10-day average closing price of our common stock prior to March 7, 2007), expiring March 7, 2011; and (3) four-year warrants to purchase 31.25 additional shares of common stock for each $1,000 borrowed (with a minimum individual draw amount of $1 million). The Company will recognize $278,000 of interest expense ratably over the term of this agreement related to these warrants, which is the fair value of the warrants for 125,000 and 62,500 shares, determined under the Black-Scholes option pricing model. The Company expensed $37,000 and $50,000 related to these warrants during the three months and six months ended June 30, 2007, respectively. To date, no amounts have been drawn on the line. Therefore, no expense has been recognized for the warrants to be issued upon borrowings on the Mezzanine Facility. The Mezzanine Facility is subordinated in right of payment only to the existing loan facilities with Comerica and GE Capital. Prepayment of all amounts owed under the Mezzanine Facility is mandatory in the event of a change of control or liquidation of the Company. In addition, all amounts owed under the Mezzanine Facility must be repaid on the later of December 6, 2008 or 90 days following full repayment of all debt under the GE Capital facility. The Company may elect to prepay the outstanding principal amount with five business days written notice to Safeguard. The Mezzanine Facility also provides Safeguard with a right of first offer/refusal for any subsequent debt facility subordinate to the GE Capital facility and Comerica line of credit. As of June 30, 2007, the Company had $6.0 million available under the Mezzanine Facility.
(10) 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, $2.0 million in 2005 and $2.3 million in 2006 of diagnostic services 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 45.9% of the cost of the equipment, respectively.
The capital lease obligations as of June 30, 2007 are as follows (in thousands):
(11) 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 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 $500,000. As the Company occupied additional square footage, the annual base rent was increased to approximately $1.0 million on June 1, 2006 and will be increased 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 $3.3 million through June 30, 2007. Such costs are capitalized as leasehold improvements and amortized over their estimated useful life, while the reimbursement is recorded to deferred rent and recovered ratably over the term of the lease.
The Company has entered into sublease agreements with two tenants for approximately 33,000 square feet. Amounts received under these leases are recognized as a reduction to rent expense over the term of each lease.
At June 30, 2007, future minimum lease payments for all operating leases, excluding scheduled sublease receipts, are as follows (in thousands):
The Company subleases portions of its facility. Expected future minimum sublease receipts to the Company as of June 30, 2007 are as follows (in thousands):
(12) Income Taxes
The Companys consolidated income tax expense for the three and six months ended June 30, 2007 was $-0- and $23,000, respectively, versus $-0- and $16,000 for the three and six months ended June 30, 2006, respectively. The consolidated income tax expense resulted from quarterly minimum estimated state tax payments. The Company has recorded a valuation allowance to reduce its net deferred tax asset to an amount that is more likely than not to be realized in future years. Accordingly, the net operating loss benefit that would have been recognized in 2007 was offset by a valuation allowance.
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Adoption of FIN 48 had no impact on the Companys consolidated results of operations and financial position.
Upon adoption of FIN 48, the Company identified uncertain tax positions that the Company currently does not believe meet the more likely than not recognition threshold under FIN 48 to be sustained upon examination. Since these uncertain tax positions have not been utilized and had a full valuation allowance established, the effect is to reduce the gross deferred tax asset and valuation allowance by $3.2 million. This amount relates to unrecognized tax benefits that would impact the effective tax rate if recognized absent the valuation allowance.
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. Tax years 2003 and forward remain open for examination for federal tax purposes and tax years 2002 and forward remain open for examination for the Companys more significant state tax jurisdictions. To the extent utilized in future years tax returns, net operating loss and capital loss carryforwards at June 30, 2007 will remain subject to examination until the respective tax year is closed.
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, our ability to obtain additional financing on acceptable terms or at all, our ability to continue to develop and expand our services business, our ability to expand and maintain a successful sales and marketing organization, continuation of favorable third party payer reimbursement for tests performed by us, our ability to maintain compliance with financial and other covenants in our credit facilities, our ability to successfully complete a joint development agreement with Zeiss for the development of novel molecular tests, whether the conditions to payment of all or any portion of the $1.5 million of contingent consideration from the sale of our Technology business to Zeiss are satisfied, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in developing any new software applications, failure to obtain Food and Drug Administration clearance or approval for particular applications, our 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 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 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 2005, we completed the first stage of the transformation of our business from ChromaVision (positioned as a medical device provider with a single application) to Clarient (positioned as a technology and services company offering a full menu of advanced tests to assess and characterize cancer). We gathered an experienced group of professionals from the anatomic pathology laboratory and the in-vitro diagnostics businesses to carefully guide this transition. We achieved a year of rapid growth by commercializing 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 key technologies. In June 2005, we signed a distribution and development agreement with Dako A/S (Dako), a Danish company recognized as a worldwide leader in pathology diagnostics systems. This enabled us to strengthen our legacy position as the leader in cellular digital image analysis with the ACIS® Automated Image Analysis System (ACIS) and accelerate our market penetration worldwide.
In 2006, we focused on the execution of our plan to capitalize on the growth of the cancer diagnostics market. We expanded on our base of immunohistochemistry (IHC) with the addition of flow cytometry and fluorescent in situ hybridization (FISH) molecular testing. These additions positioned Clarient to move beyond solid tumor testing into the important area of leukemia/lymphoma assessment. We also completed a consolidation of our business with the move into a state-of-the-art facility without disruption to our customers.
In March 2007, we entered the second stage of our business strategy by selling our instrument systems business (which developed, manufactured and marketed the ACIS) and related intellectual property assets (the ACIS Sale) to Carl Zeiss MicroImaging, Inc. (Zeiss), an international leader in the optical and opto-electronics industries. The ACIS Sale provides
us the financial resources to focus our efforts on the most profitable and fastest growing opportunities within our services business. We believe our strength as a leading cancer diagnostics laboratory, our deep domain expertise and access to robust intellectual property can propel our continued growth through the development of additional tests, unique analytical capabilities and other service offerings.
Our focus is on identifying high-quality opportunities to increase our profitability and differentiate Clarients service offerings in our highly-competitive market. An important aspect of our strategy is to create near- and long-term, high margin revenue generating opportunities by connecting our medical expertise with our intellectual property to develop novel diagnostic tests (sometimes also referred to as novel markers or biomarkers) and analytical capabilities. Novel diagnostic tests are characteristics of an individuals tumor or disease that, once identified and qualified, allow for more accurate prognosis, diagnosis and treatment. In addition, we are working to identify specific partners and technologies to assist in the commercialization of these novel diagnostic tests. Broader discovery and use of novel diagnostic tests is hoped to clarify and simplify decisions for healthcare providers and the biopharmaceutical industry. The growing demand for personalized medicine has generated a need for these novel diagnostic tests, creating a new market expected to reach $1 billion in three to five years based on our internal estimates.
In 2007, we are focusing on four primary areas:
· Financial discipline to achieve break-even in our cash flow from operations;
· Operational discipline to achieve scaleable operations;
· Commercial discipline to target the right customers; and
· Strategic discipline to invest in high-value expansion opportunities to create shareholder value.
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 made the decision to provide 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. We have been experiencing revenue growth since the inception of this business line indicating excellent execution of our sales plan and solid market acceptance of our service offerings. Management must manage the growth of this business, particularly related to billings, collections and business processes. We have yet to reach optimal financial metrics related to cash flow and operating margins due to our limited history in providing lab services.
Selling, general and administrative (SG&A) expenses for the three months ended June 30, 2007 were 69% of revenue, compared to 95% in the comparable period of 2006. We expect an improving trend to 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) administration expenses related to diagnostic services, particularly the costs of pathology services; 3) key business development initiatives focused on targeted cancer therapies in various stages of clinical study; and 4) 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 future growth. Management believes that our existing cash resources, including the cash proceeds from the ACIS Sale and anticipated revenues from our laboratory services business, together with access to our existing financing sources described below, will be sufficient to satisfy the cash needs of our existing operations through at least the next 12 months. However, we may require additional debt or equity financing if we are either unable to access one or more of these financing sources, if we enter into an acquisition or other transaction requiring cash resources, or if we encounter difficulties in executing our business plan.
Characteristics of our revenue and expenses
Revenue and Billing. Revenues are derived primarily from billing insurers, pathologists and patients for the diagnostic services that we provide.
Third party billing. The majority of our revenue is currently generated from patients who utilize insurance coverage from Medicare or other third party insurance companies. In these situations, we bill an insurer that pays a portion 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.
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 CPT code (88361) appropriate for computer-assisted 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 reflects a technical component and a professional component. 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. For 2007, these rates were established at approximately $158 per test, which reflects approximately $98 for the technical component and $60 for the professional interpretation. In California, where our laboratory performs these tests for our diagnostic services operation, 2006 reimbursement was $195 per test, of which $122 was for the technical component and $73 was for professional interpretation. For 2007, these rates were adjusted to approximately $186 per test, which reflects approximately $120 for the technical component and $65 for the professional interpretation.
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 amounts 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.
Cost of Revenue and Gross Margin. Cost of revenue includes laboratory personnel, depreciation of laboratory equipment, 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.
Selling, General and Administrative Expenses. Selling, general and administrative expenses primarily consist of the salaries, benefits and costs attributable to the support of our operations, such as: information systems, executive management, financial accounting, purchasing, administrative and human resources personnel, as well as office space and recruiting, legal, auditing and other professional services. Our current sales resources are 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. In addition, we incur administration costs of senior medical staff, senior operations personnel, collection costs, consultants and legal resources to facilitate implementation and support of our operations. Collection costs are incurred from a third party billing and collection company that we have engaged to perform these services because of 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 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 and reserves.
For estimated bad debts, we review the age of receivables in various financial classes and estimate the uncollectible portion based on the type of payer and age of the receivables. However, we have outsourced the direct billing and collection of laboratory related receivables, and we work closely with our outsourced billing partner to review the details of each laboratory related account.
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 that are greater than those allowable for payment. These differences are described as contractual discounts. As noted, however, it is only the expected payment from these parties which is net of these contractual discounts that is recorded as revenue.
Three Months Ended June 30, 2007 Compared with Three Months Ended June 30, 2006
The following table presents our results of operations (excluding discontinued operations) as percentages:
Revenue increased 62% or $3.9 million from, $6.4 million in the second quarter of 2006 to $10.3 million in the second quarter of 2007. This increase resulted from the execution of our marketing and sales strategy to increase our sales to new and existing customers and to enter into new managed care contracts. This increase was also driven in part by expanding our test offerings performed to include immunohistochemistry, flow cytometry and FISH. We anticipate revenues will continue to increase as a result of increased revenue from existing customers, additions of new customers (including managed care providers) by our sales force, and our offering of a more comprehensive suite of advanced cancer diagnostic tests.
Cost of Revenue and Gross Margin
Cost of revenue for the quarter ended June 30, 2007 was $5.5 million compared to $3.4 million for the second quarter of 2006, an increase of 60%. These costs included laboratory personnel, lab-related depreciation expense, laboratory supplies and other direct costs such as shipping. Gross margin in the second quarter of 2007 was 47%, compared to 46% in the comparable period in 2006. The increase in gross margin in the second quarter of 2007 was attributable to achieving economies of scale in our operations. We anticipate similar or improving gross margins throughout 2007.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for the second quarter 2007 increased $1.0 million, or 17% to $7.1 million from $6.1 million for the comparable period in 2006. As a percentage of revenue, these expenses decreased from 95% for the quarter ended June 30, 2006 to 69% for the quarter ended June 30, 2007. The increase in expenses in 2007 was due primarily to expenses to generate and support revenue growth and to improve infrastructure, including selling and marketing expenses, billing and collection costs, and facility overhead to expand service capacity. In addition, we have increased headcount and consulting resources in information technology to support future revenue growth throughout 2007, and we have incurred incremental stock-based compensation expense for non-employees with the increase in our stock price. We anticipate sales expenses will continue to grow in 2007 to support our expected revenue growth, and we expect general and administrative expenses to decline as a percentage of revenues as our infrastructure costs stabilize.
Interest expense for the three months ended June 30, 2007 totaled $0.5 million, compared to $0.1 million for the comparable period in 2006. The increase was due to higher outstanding borrowings under our financing facilities.
Six Months Ended June 30, 2007 Compared with Six Months Ended June 30, 2006
The following table presents our results of operations (excluding discontinued operations) as percentages:
Revenue for the six months ended June 30, 2007 was $19.2 million compared to $11.9 million for the same period of 2006, an increase of 62% or $7.3 million. This increase resulted from the execution of our marketing and sales strategy to increase our sales to new and existing customers and to enter into new managed care contracts. This increase was also driven in part by expanding our test offerings to include immunohistochemistry, flow cytometry and FISH. We anticipate revenues will continue to increase as a result of increased revenue from existing customers, additions of new customers (including managed care providers) by our sales force, and our offering of a more comprehensive suite of advanced cancer diagnostic tests.
Cost of Revenue and Gross Margin
Cost of revenue for the six months ended June 30, 2007 was $10.6 million, compared to $6.7 million for the comparable period of 2006, an increase of 58%. These costs include laboratory personnel, lab-related depreciation expense, laboratory supplies and other direct costs such as shipping. Gross margin for the six months ended June 30, 2007 was 45%, compared to 44% in the comparable period of 2006. The increase in gross margin in 2007 was attributable to achieving economies of scale in our operations. We anticipate similar or improving gross margin results throughout 2007.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for the six months ended June 30, 2007 increased $2.2 million, or 18%, to $14.1 million compared to $12.0 million for the comparable period in 2006. As a percentage of revenue, these expenses decreased from 101% for the six months ended June 30, 2006 to 74% for the six months ended June 30, 2007. The increase in expenses in 2007 was due primarily to expenses to generate and support revenue growth and to improve infrastructure, including selling and marketing expenses, billing and collection costs, and facility overhead to expand service capacity. In addition, we have increased headcount and consulting resources in information technology to support future revenue growth throughout 2007, and we have incurred incremental stock-based compensation expense for non-employees with the increase in our stock price. We anticipate sales expenses will continue to grow in 2007 to support our expected revenue growth, and we expect general and administrative expenses to decline as a percentage of revenues as our infrastructure costs stabilize.
Interest expense for the six months ended June 30, 2007 was $1.4 million, compared to $0.4 million for the comparable period of 2006. The increase was due to higher outstanding borrowings under our financing facilities and warrants issued to affiliates of Safeguard Scientifics, Inc. (collectively with its affiliates Safeguard), our majority stockholder, in exchange for debt-guarantee fees related to our Comerica facility. The fair value of $0.3 million related to these warrants was included in interest expense in the six months ended June 30, 2007.
In March 2007, we completed the sale of our instrument systems business and related intellectual property assets (the Technology business) for net proceeds of $10.3 million (the ACIS Sale). As a result of the sale, we recorded a gain of $6.2 million in the first quarter of 2007, which was partially offset by operating losses of $0.8 million during the first quarter of 2007 and $36,000 of adjustments to the gain during the second quarter of 2007.
Liquidity and Capital Resources
At June 30, 2007, we had approximately $2.6 million of cash and cash equivalents and $8.2 million available under our revolving lines of credit and Mezzanine Facility. Cash used in operating activities was $7.6 million for the six months ended June 30, 2007 and was due primarily to our loss from continuing operations of $6.8 million, a decrease in accounts payable of $2.3 million, an increase in accounts receivable of $1.9 million, and cash used in operating activities of discontinued operations of $0.8 million, partially offset by non-cash costs and expenses of $3.4 million for depreciation, stock-based compensation and bad debt. Cash provided by investing activities of $8.5 million consisted of the proceeds, net of selling costs, of $10.3 million received from the sale of the Technology business, partially offset by capital expenditures of $1.7 million related primarily to new laboratory equipment and information technology infrastructure enhancements. Net cash provided by financing activities during the first six months of 2007 was $1.4 million and was attributable primarily to net borrowings of $2.4 million under our revolving lines of credit, partially offset by principal payments of $1.0 million on capital leases.
In June 2004, we entered into a master lease agreement with General Electric Capital Corporation (GE Capital) for capital equipment financings of diagnostic services (laboratory) related equipment. We financed $2.6 million in 2004, $2.0 million in 2005 and $2.3 million through December 31, 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 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 an early purchase option after 24 months for an average purchase price equal to 44.8% and 45.9% of the original cost of the equipment, respectively. The Company intends to purchase this equipment at the end of the lease term. 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.
In July 2005, we signed a ten-year lease for a new 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 of 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 $8.2 million. As of June 30, 2007, we have spent approximately $7.9 million on tenant improvements and equipment purchases to build out the facility. We expect to spend approximately $0.3 million to complete the facility project. Of the $7.9 million spent through June 30, 2007, the landlord has funded $3.3 million and we expect the landlord to fund the balance of $0.2 million of lessor concession as we complete the remaining tenant improvements of the new facility. We have scheduled rent payments of $0.5 million over the remainder of 2007. During the first quarter of 2007, we entered into sublease agreements with two tenants who are expected to make lease and common area expense payments of $0.3 million through the remainder of 2007.
On September 22, 2006, we entered into a securities purchase agreement with Safeguard pursuant to which Safeguard purchased 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 $3.0 million. The purpose of this financing was to fund the purchase of Trestle Holdings, Inc., and Trestle Acquisition Corp. (a wholly-owned subsidiary of Trestle Holdings, Inc.) (collectively, Trestle), and is referred to as the Trestle Financing. In exchange for Safeguards funding commitment, we also issued Safeguard 50,000 warrants to purchase common stock at an exercise price of $0.87 per share (reflecting the trailing 10-day average closing price of our common stock prior to June 19, 2006.) The warrants issued in the Trestle Financing 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 our outstanding common stock. In connection with this financing, we agreed to register the shares purchased by Safeguard upon request by Safeguard.
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 lockboxes. The credit agreement includes an annual collateral monitoring fee of $12,000, and the following two financial covenants: one related to either a minimum fixed charge coverage ratio of 1.00 to 1.00, or a minimum liquidity requirement
of three months cash burn (defined as balance sheet cash plus excess borrowing base available under the credit agreement), and one related to tangible net worth, which is required to be not less than $0.6 million through September 29, 2007 (with further reductions to negative $500,000 through December 30, 2007 and to negative $1.1 million at December 31, 2007 and for monthly periods thereafter). The Company obtained a waiver from Comerica of the Companys failure to comply with the revised tangible net worth covenant as of May 31, 2007, and the Company was in compliance with all financial covenants as of June 30, 2007. The Company believes it will remain compliant with its financial covenants for at least the next 12 months. The facility has a two-year term and is secured by accounts receivable, along with all of our other assets and 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. In March 2007, a portion of the proceeds from the ACIS Sale reduced amounts outstanding to GE. At June 30, 2007, we had $1.3 million of borrowings outstanding under this $5.0 million facility, and had $2.2 million of availability based on the amount of our qualified accounts receivable.
We currently have a $12.0 million revolving credit agreement with Comerica Bank (the Comerica Facility), which was increased from $8.5 million in January 2007, and expires on February 27, 2008. Borrowings under the Comerica Facility totaling $9.0 million at June 30, 2007 are being used for working capital purposes, and a $3.0 million stand-by letter of credit was provided to the landlord of our leased facility and bears interest at the banks prime rate minus 0.5%. The Comerica Facility also includes an annual facility fee of $27,500 and one financial covenant related to tangible net worth, which is required to be not less than $0.6 million through September 29, 2007 (with further reductions to negative $500,000 through December 30, 2007 and to $1.1 million at December 31, 2007 and for monthly periods thereafter). Borrowings under the Comerica Facility 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. Additionally, we are required to pay Safeguard a quarterly usage fee of 0.875% of the amount by which the daily average principal balance outstanding under the Comerica line of credit exceeds $5.5 million. We also issued warrants to Safeguard as consideration for their guarantee as follows: (1) warrants to purchase 50,000 shares of common stock for an exercise price of $2.00 per share (for Safeguards guarantee of $8.5 million), (2) warrants to purchase 100,000 shares for an exercise price of $0.01 (as a commitment fee for Safeguards guarantee of the $3.5 million increase in the line), and (3) warrants to purchase 166,667 shares for an exercise price of $1.64 (as a maintenance fee for Safeguards guarantee of the $3.5 million increase in the line). The fair value of warrants issued, determined under the Black-Scholes model, is recognized as expense over the applicable period of the commitment. At June 30, 2007, we had no availability under the Comerica Facility. The Company obtained a waiver from Comerica of the Companys failure to comply with the revised tangible net worth covenant as of May 31, 2007, and the Company was in compliance with all financial covenants as of June 30, 2007. The Company believes it will remain compliant with its financial covenants for at least the next 12 months.
On March 7, 2007, we obtained a subordinated revolving credit line (the Mezzanine Facility) from a Safeguard affiliate. The Mezzanine Facility, which expires December 8, 2008, provides us access to up to $6.0 million in working capital funding as we continue to grow our business. The Mezzanine Facility was originally $12.0 million, but was reduced by $6.0 million as a result of the ACIS Sale. Borrowings on the Mezzanine Facility will bear interest at an annual rate of 12%. In connection with the Mezzanine Facility, we issued (or are required to issue) to Safeguard: (1) warrants to purchase 125,000 shares of our common stock with an exercise price of $0.01 per share, expiring March 7, 2011; (2) warrants to purchase 62,500 shares of common stock with an exercise price of $1.39 per share (reflecting a 15% discount to the trailing 10-day average closing price of our common stock prior to March 7, 2007), expiring March 7, 2011; and (3) four-year warrants to purchase 31.25 additional shares of common stock for each $1,000 borrowed (with a minimum draw amount of $1 million). To date, no amounts have been drawn on the line.
We believe that our existing cash resources, including the cash proceeds from the ACIS Sale and anticipated revenues, together with access to the financing sources described above, will be sufficient to satisfy the cash needs of our existing operations for at least the next 12 months. However, we have a history of operating losses and negative cash flows from operations, and future profitability is uncertain. If we are unable to achieve positive cash flow, we may fail to comply with one or more of our debt covenants, which may, if not waived, accelerate our outstanding indebtedness. Moreover, if we are unable to access one or more of our financing sources, 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 may require additional debt or equity financing. 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 June 30, 2007, including our facility lease and borrowings on equipment subject to operating leases. These commitments exclude scheduled sublease receipts, 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 facility.
The Company subleases portions of its facility. Future minimum sublease receipts as of June 30, 2007 are as follows:
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 June 30, 2007, 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. None of these standards had a material impact on our financial position, results of operations, or liquidity. See Note 7 of the Notes to Condensed Consolidated Financial Statements.
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 short time;
· adequate coverage and reimbursement;
· medical efficacy as demonstrated by clinical studies and governmental clearances; 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.
We have a history of operating losses, and future profitability is uncertain. We have incurred operating losses in every year since inception, and our accumulated deficit as of June 30, 2007 was $137.7 million. Those operating losses are principally associated with the research and development of our ACIS technology (which we transferred to Zeiss in the ACIS Sale), the conducting of clinical trials, preparation of regulatory clearance filings, the development of Dakos sales and marketing organization to commercialize the ACIS and the investments we have made relating to our diagnostic services business.
Although we have significantly reduced our operating losses, we expect to continue to incur losses as a result of expansion of our laboratory services. 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 will decline.
Although we believe the cash proceeds from the ACIS Sale, as well as our available credit lines, will be sufficient to fund our business operations, we may require additional financing for, among other things, expansion of our laboratory operations, development of novel molecular tests, capital expenditures and other costs, and it is uncertain whether such financing will be available on favorable terms, if at all.
We will continue to expend funds for development, clinical trials and expanding our service offerings. We will also need additional capital if our new business initiatives are not successful or we fail to achieve the level of revenues and gross profit from our services in the time frame contemplated by our business plan.
Our present and future funding requirements will also depend on certain other external factors, including, among other things:
· the level of development investment required to maintain and improve our service offerings; including the development of novel molecular tests;
· 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, 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.
We are required to maintain compliance with financial and other restrictive covenants in our debt financing agreements which can restrict out ability to operate our business, and if we fail to comply with those covenants, our outstanding indebtedness may be accelerated.
Our existing financing agreements with Comerica, GE Capital and Safeguard 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 exist) 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. During 2006 and 2007, we were unable to comply with certain of the financial covenants (including the requirement that we maintain a minimum tangible net worth) under our credit agreements with GE Capital and Comerica Bank. While our lenders have waived those defaults and we have agreed to new financial covenants with respect to future periods, if a default occurs in the future, 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 have identified material weaknesses in our internal control over financial reporting.
We identified a material weakness in our internal control over financial reporting as of March 31, 2007 as a result of insufficient compensating controls in our accounting for accounts receivable and contractual allowances. Although we believe we have remediated this weakness during the second quarter of 2007, we may in the future identify further material weaknesses in our internal control over financial reporting that we have not discovered to date.
We recently sold our Technology business to Zeiss and we may experience negative consequences as a result of such transaction, including disruptions to our operations, potential indemnification obligations and restrictions on our business operations going forward.
In March 2007, we sold our Technology business to Zeiss in the ACIS Sale for an aggregate purchase price of $12.5 million, consisting of $11 million in cash and up to an additional $1.5 million in contingent purchase price, which is payable in whole or in part (if at all) subject to satisfaction of certain post-closing conditions relating to intellectual property. We cannot assure that those conditions will be satisfied and, as a result, we may be paid only a portion or none of such contingent consideration.
The ACIS Sale resulted in the transfer of our legacy business of developing, manufacturing and marketing the ACIS system, and, as a result, we will no longer derive revenues from that business, including revenues under our distribution agreement with Dako (which we assigned to Zeiss in connection with the transaction). We also transferred our patent portfolio and other intellectual property of the Technology business to Zeiss and while we have retained a license to certain patent rights, copyrights and software, our use of those intellectual property rights is limited to the field of use specified in the license agreement. We also agreed not to compete with Zeiss in connection with the development, production and sale of imaging instruments for a period of 42 months following the closing date and, as a result, our business will be restricted from engaging in those activities during that period.
In addition, the transfer of our Technology business to Zeiss may result in disruptions to our business. For example, we are required to provide certain transition services to Zeiss until September 2007 which could significantly divert the time and resources of our management and other personnel. In addition, we may encounter difficulties in effecting the transfer of the assets of the Technology business to Zeiss and in connection with the separation of the Technology business from our other operations.
In connection with the ACIS Sale, we also made customary representations and warranties to Zeiss and we retained certain pre-closing liabilities relating to the Technology business. As a result, we may have future indemnification obligations to Zeiss in the event of a breach of such representations or if there are third party claims relating thereto or to the liabilities that we retained.
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 would 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 diagnostic laboratory 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. Our future success will depend upon our ability to enhance our current tests, and to develop new tests, 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.
The 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 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 increased with 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.
Furthermore, we believe some of our current competitors, as well as other currently non-competitive companies, are actively engaged in research in areas where we are also performing product development. The resulting products from these companies may directly compete with our potential products or may address other areas of diagnostic evaluation. The competitive markets for our potential products may be dependent on timing of entries into the markets. Early entry may provide a company with an advantage in gaining product acceptance contributing to the products eventual success in the market. Therefore, speed in development and in achieving clinical study and regulatory success may provide an advantage.
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 are able to. Our competitors also might develop more effective technologies or products 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, management of medical data and dissemination of test results. 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.
Our facility may be affected by catastrophes such as fires, earthquakes or sustained interruptions in electrical service. Earthquakes are of particular significance to us because our laboratory facility is located in southern California, an earthquake-prone area. In the event our existing facility 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.
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;
· Ken Bloom, M.D., our Chief Medical Director;
· Karen Garza, our Senior Vice President, Strategic Planning and Business Development;
· Jose de la Torre-Bueno, Ph.D., our Vice President and Chief Technology Officer; and
· David J. Daly, our Senior Vice President of Commercial Operations.
As previously reported, in June 2007 James Agnello, our Senior Vice President and Chief Financial Officer, took a short term medical leave of absence. Mr. Agnello has since returned from his medical leave and is expected to make a full recovery.
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. We do not maintain key-person life insurance on any of our officers, scientific and technical personnel or other employees. 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. These individuals may not be able to fulfill their responsibilities adequately and may not remain with us.
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 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 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 diagnostic 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;
· disputes with payers as to which party is responsible for 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 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.
We are dependent on others for the development of products. The failure of our collaborations to successfully develop products could harm our business.
Our business strategy includes entering into agreements with clinical and commercial collaborators and other third parties for the development, clinical evaluation and marketing of new products, including novel molecular tests. Research performed under a collaboration for which we receive or provide funding may not lead to the development of products in the timeframe expected, or at all. If these agreements are terminated earlier than expected, or if third parties do not perform their obligations to us properly and on a timely basis, we may not be able to successfully develop new products as planned, or at all.
We 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.
We may make 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 an acquisition and integrating an acquired business will 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 and financial condition.
Clinicians or patients using our 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 $5 million aggregate, $3 million per claim, professional liability insurance policy. This policy has a deductible of $25,000 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 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 licensed proprietary technology, or any determination that our licensed 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. 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 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 patents we may obtain in the future 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 licensed 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 using a technology or providing a service 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 intellectual property; and
· we may have to redesign our services so that they do 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
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. The 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. The 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.
If we are not able to obtain all of the regulatory approvals and clearances required to commercialize our services and underlying diagnostic applications, our business would be significantly harmed.
In most cases, the development and commercialization of 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 12 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 (but possibly longer) from submission. We do not know whether we will be able to obtain the clearances or approvals required to commercialize these products. 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.
The FDA has made, and may continue to make, changes in its approval requirements and processes. We cannot predict what these changes will be, how or when they will occur or what effect they will have on the regulation of our products. Any new regulations may impose additional costs or lengthen review times of our products. Delays in receipt of or failure to receive United States regulatory approvals or clearances for our new products would have a material adverse effect on our business, financial condition and results of operations.
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 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. 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.
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 to challenge providers and suppliers. 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 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 (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 include self-referral prohibitions which prevent us from accepting referrals from physicians who have non-exempt ownership or compensation relationships with us. There are other rules governing billing markups 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 Program 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 also 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 required us to adopt a Unique Health Identifier for use in filing and processing health care claims and other transactions beginning 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 and the related description of our business under the heading Governmental Regulatory Status in Item 1 of our Annual Report on Form 10-K. 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 contracts with third party billing services to bill third party payers or patients. Clarient also provides or procures all of the resources for cash collection and management of accounts receivables, including custody of the lockbox where cash receipts are deposited. 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 executes 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 our operations do not comply with applicable law or that could otherwise adversely affect our operations. In addition, the health care regulatory environment may change in a manner that restricts 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 developed 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 diagnostic companies is 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 may be 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 owns a majority of our outstanding common stock and has rights, subject to some conditions, to require us to file registration statements covering shares owned by it and to include its shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we file a registration statement shares and include 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 agreed that our board of directors will have 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:
· securities analysts may not continue or initiate coverage of Clarient; and
· we may lose current or potential investors.
In addition, 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.
Recently enacted and proposed changes in securities laws and regulations will increase our costs.
The Sarbanes-Oxley Act of 2002 along with other recent and proposed rules from the Securities and Exchange Commission and Nasdaq required changes in our corporate governance, public disclosure and compliance practices. Many of these new requirements have increased our legal and financial compliance costs, and make some corporate actions more difficult, such as proposing new or amendments to stock option plans, which now require shareholder approval. These developments could make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments also could make it more difficult for us to attract and retain qualified executive officers and qualified members of our board of directors, particularly to serve on our audit committee.
We invest excess cash in short-term debt securities that are intended to be held to maturity. These short-term investments typically have various maturity dates which do not exceed one year. We had no short-term investments as of June 30, 2007.
Two of the main risks associated with these investments are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of debt securities. Fluctuations in interest rates would not have
a material effect on our financial statements because of the short-term nature of the securities in which we invest and our intention to hold the securities to maturity. Credit risk refers to the possibility that the issuer of the debt securities will not be able to make principal and interest payments. We have limited the investments to investment grade or comparable securities and have not experienced any losses on our investments to date due to credit risk.
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that we would meet our disclosure obligations.
As reported in Item 4 of our Quarterly Report on Form 10-Q (for the quarter ended March 31, 2007) filed with the Securities and Exchange Commission on May 9, 2007, management identified a material weakness in our internal control over financial reporting as of March 31, 2007 as a result of insufficient review controls. Management reached this conclusion as a result of the discovery of an error in our calculation of the estimated contractual discount percentage we provide to third party payers, which percentage directly impacts our calculation of revenue and accounts receivable, and indirectly the allowance for doubtful accounts. The error resulted from the use of incorrect data and insufficient management review. This error, if it had gone undetected, would have resulted in an overstatement of our revenues and accounts receivable of approximately $400,000 as of and for the three months ended March 31, 2007. The error was discovered during the independent review of, and prior to the completion of, the condensed consolidated financial statements as of and for the quarter ended March 31, 2007, and an adjustment was made to those condensed consolidated financial statements included in that report to correct the error. During the quarter ended June 30, 2007, the company implemented additional review procedures which management believes have remediated this material weakness. Except for this change, there have been no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to affect, our internal control over financial reporting.
There have been no material changes in our risk factors from the information set forth in our Annual Report on Form 10-K for the year ended December 31, 2006.
We held our Annual Meeting of Stockholders on June 27, 2007. At the meeting, the stockholders voted in favor of electing as directors the 8 nominees named in the Proxy Statement dated May 25, 2007.
The number of votes were as follows:
Also at the annual meeting, the stockholders voted in favor to approve the Companys 2007 Incentive Award Plan.
The number of votes were as follows:
Also at the annual meeting, the stockholders voted in favor to ratify the appointment of KPMG LLP as the Companys independent registered public accounting firm for the fiscal year ending December 31, 2007. The number of votes were as follows:
The following is a list of exhibits required by Item 601 of Regulation S-K filed as part of this Report.
(a) Filed on June 29, 2007 as an exhibit to the Companys Current Report on Form 8-K and incorporated herein by reference.
(b) Filed on July 16, 2007 as an exhibit to the Companys Current Report on Form 8-K and incorporated herein by reference.
Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.