ORE PHARMACEUTICAL HOLDINGS INC. 10-K 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File Number: 0-23317
GENE LOGIC INC.
(Exact name of registrant as specified in its charter)
50 West Watkins Mill Road
Gaithersburg, Maryland 20878
(Address of Principal Executive Offices)
Registrant’s phone number, including area code: (301) 987-1700
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
(Title of Class)
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act: YES ¨ NO x
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act: YES ¨ NO x
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: YES x NO ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K: YES x NO ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): YES ¨ NO x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. (Rule 12b-2 of the Exchange Act):
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
The aggregate market value of the voting stock (which consists solely of shares of Common Stock) held by non-affiliates of the Registrant as of June 30, 2006 was approximately $41,881,719.60, based on the closing price on that date of Common Stock on The NASDAQ Stock Market.*
The number of shares outstanding of the Registrant’s Common Stock, $.01 par value, was 31,820,273 as of March 1, 2007.
* Excludes 786,135 shares of Common Stock held by directors and executive officers and stockholders whose beneficial ownership exceeds 10% of the shares outstanding on June 30, 2006. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the Registrant, or that such person is controlled by or under common control with the Registrant.
TABLE OF CONTENTS
This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements regarding future events and the future results of Gene Logic Inc. (“Gene Logic”) that are based on current expectations, estimates, forecasts and projections about the industries in which Gene Logic operates and its business and the beliefs and assumptions of the management of Gene Logic. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” variations of such words, and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause or contribute to such differences include those discussed in this Form 10-K under the section entitled “Risk Factors”. Gene Logic undertakes no obligation to revise or update publicly any forward-looking statements to reflect any change in management’s expectations with regard thereto or any change in events, conditions, or circumstances on which any such statements are based.
Unless the context otherwise requires, references in this Form 10-K to “Gene Logic,” “Gene Logic Laboratories Inc.,” “Gene Logic Ltd.,” “Gene Logic K.K.,” the “Company,” “we,” “us,” and “our” refer to Gene Logic Inc. and its wholly owned subsidiaries. Gene Logic®, BioExpress®, ToxExpress®, ASCENTA® and Genesis Enterprise System® are registered trademarks of Gene Logic. ToxShield™ is a trademark of Gene Logic. GeneChip® is a registered trademark of Affymetrix, Inc. Viagra® is a registered trademark of Pfizer, Inc. Evista® is a registered trademark of Eli Lilly & Co. Hytrin® is a registered trademark of Abbott Laboratories.
Gene Logic Inc. was incorporated in September 1994 as a Delaware corporation and commenced operations in 1996. In 1997, we completed our initial public offering. Our stock is traded on The NASDAQ Stock Market under the symbol “GLGC”. In 1998, we purchased Oncormed, Inc., which brought us new expertise in tissue sample management and use of microarray technologies. In 2003, we purchased TherImmune Research Corporation, renamed it Gene Logic Laboratories Inc. and subsequently referred to it in our SEC filings as our Preclinical Division. We sold Gene Logic Laboratories on December 15, 2006, to a privately held company. In 2004, we acquired certain technologies from Millennium Pharmaceuticals, Inc., which, in combination with our genomics databases and proprietary software, are the basis for our current pharmaceutical development business.
We are headquartered in Gaithersburg, Maryland. Our principal executive offices are located at 50 West Watkins Mill Road, Gaithersburg, Maryland 20878, and our telephone number is (301) 987-1700. Our Internet site is www.genelogic.com. Material contained on our Internet site is not incorporated by reference into this Form 10-K.
In 2004, Gene Logic created a pharmaceutical development division (known as our Drug Repositioning division) within the Company to identify and develop new or expanded uses for small molecule therapeutics. Based on advances in our pharmaceutical development division and changes in our Genomics business, and after recently concluding a comprehensive review of our strategy, we have decided to focus our resources on becoming a pharmaceutical development company. We are now building a therapeutic pipeline by applying our proprietary drug indication discovery platform to find new and expanded uses for drug candidates supplied by major pharmaceutical companies with whom we have drug development partnerships. We believe this strategy is the best way to create value for shareholders.
In 2005 and 2006, we entered into drug repositioning and development (“drug development”) partnerships with Pfizer, F. Hoffmann-La Roche Ltd, Eli Lilly and Co., and NV Organon. Our partners provide us with drug candidates that have already been assessed as safe in human clinical trials, and whose development for their original indications has been discontinued. Our drug development partnerships are generally structured to provide us with milestone payments for repositioned drug candidates that our partners return to clinical development for indications that we have identified, and long-term value in the form of royalties or other co-ownership positions.
We apply, at our own expense, our drug indication discovery platform to identify new uses for these clinical-stage drug candidates. This platform consists of genomics databases and bioinformatics software developed by Gene Logic over the past 10 years, and biological screening technologies acquired from Millennium Pharmaceuticals and which subsequently have undergone further development. In 2006, we began evaluating more than 40 drug candidates for our drug development partners. Based on our experience to date, we have been able to develop alternative indication hypotheses for 25%-33% of the candidates for which evaluation is complete. Some of the candidates for which we have found new indications have or will progress to in vivo efficacy models to evaluate and support their suitability for re-entering clinical trials for the proposed new indications. For the candidates that will shortly begin in vivo efficacy studies, our partners have agreed to fund a portion of the costs associated with these studies. We expect that some portion of the drug candidates will have successful outcomes in the in vivo tests and will be selected by our partners to re-enter clinical trials, but we do not yet have sufficient data to estimate the rate of clinical trial re-entry. We do not expect any of these drug candidates to re-enter clinical trials, if at all, until after 2007.
In the event that a partner chooses not to pursue development of a candidate for which we find a new indication, we may seek to acquire the repositioned candidate and may choose to further develop it ourselves or outlicense it to third parties. For example, in 2006, we acquired certain rights from Millennium Pharmaceuticals to a drug candidate for which we have identified potential new indications.
From 1996 through 2006, our business was primarily devoted to developing and commercializing proprietary genomic and toxicogenomic databases, toxicogenomic services, software tools and other services. The Genomics services we provide enable customers worldwide to discover and prioritize drug targets, identify biomarkers, predict toxicity and understand mechanisms of toxicity, and understand mechanisms of action of specific compounds.
In 2006, we began to redirect our Genomics Division in response to our customers’ shifting their research activities from early-stage drug discovery into later-stage development and validation efforts and a resulting decline in sales of our Genomics licenses. In August, we took steps to reduce the staffing and expense levels in this business. We examined the business for new avenues to create value and concluded that our commercially demonstrated expertise in biomarker discovery and validation could be used as a potential new platform for molecular diagnostics development. As a result, we have engaged outside financial advisors to identify strategic alternatives for our Genomics business. We continue to serve new and existing Genomics customers.
In December 2006, we sold our Preclinical Division. The Preclinical Division provided contract research services to assess the safety and pharmacologic effects of compounds to support regulatory submissions for human clinical trials. We decided to sell the Preclinical Division because the business provided insufficient strategic or synergistic advantage to our pharmaceutical development, genomics or molecular diagnostic efforts. The sale included four of our leased facilities and the transfer of approximately 200 employees.
The Drug Discovery and Development Process
The process of drug development is expensive, time consuming and risky. On average it takes 13 years from the beginning of the discovery effort to get a drug to market and, while research and development costs have been doubling every five years, success rates for getting drugs to market have been flat or declining.
Today, drug discovery and development in the United States generally consists of the following steps:
A significant number of drug candidates are halted at some point in the discovery and development process. Candidates may have toxicity issues, lack efficacy in the targeted therapeutic application, be difficult to manufacture, have a narrow market, or be inferior to competitive products, among other issues. Drug repositioning is generally defined by the industry as either (i) finding new uses for drug candidates discontinued during the clinical phases or (ii) finding uses for marketed drugs in additional therapeutic applications.
Biological Function and Genomics
The cells of all living organisms contain a blueprint or set of instructions for how each cell-type should work. This blueprint is passed from one generation to the next and is encoded in a set of molecules called deoxyribonucleic acid (“DNA”). These DNA molecules are organized into long strands that bind to each other in a twisted double helix structure. DNA molecules can be organized in a vast number of different ways, leading to the production of millions of different protein molecules. These protein molecules are the basic building blocks of all living organisms.
Protein molecules are produced from DNA utilizing an intermediate molecule called messenger ribonucleic acid (“mRNA”), which translates DNA into protein form. The specific sequence of DNA that produces a particular protein is called a gene. In humans, every cell contains three billion base pairs of DNA molecules, referred to collectively as the human genome. Only a small percentage of the genome actively produces proteins.
Cells are very different from each other in structure and function despite the fact that they share the same genetic blueprint. For example, a brain cell and a muscle cell, although very different, contain exactly the same DNA code. The reason for the difference in structure and function is that not all genes are active in any cell. The type of cell and its function are determined by which genes are actively producing protein and the amount of protein they are producing. In fact, almost any change in the activity of a cell, whether normal or diseased, is reflected in a change in the genes that are producing protein. This pattern of gene activity is called gene expression. The determination of patterns of gene expression is a broad measure of the function of a cell.
Microarray technology has accelerated the process of measuring gene expression. Microarray technology uses millions of DNA sequences attached to a solid surface in a dense matrix. Samples of cells and tissues from humans or animals are prepared, and the resulting mRNA is then labeled and exposed to the surface of the microarray. The labeled mRNA adheres to its counterpart DNA on the microarray, resulting in information which can then be analyzed to determine the level and pattern of gene expression within that tissue or cell.
While the biology of different normal and diseased cells can be evaluated by analyzing gene expressions patterns, there are also variations of the gene sequence for similar genes from individual to individual. These individual variations in gene sequence, known as SNPs, account for similar proteins working more or less effectively. These differences in protein function lead to individual variations in the effectiveness of drugs, susceptibility to disease, and toxicity of compounds. There may be hundreds or thousands of variations within any gene from one individual to another. There are thought to be about three million significant SNPs in the human genome, although not all of them have yet been discovered and the function for most is not known. These variations are determined by various methods and machines that allow a DNA sequence to be analyzed.
Different patterns of gene expression are associated with normal and diseased cells, as well as either the toxic or therapeutic effect that drugs can have on cells.
For example, a cancerous tissue can be compared to normal tissue to find aberrant gene activity that is associated with the cancer, and that information can be used to identify biomarkers (a molecular marker associated with a biological function) and targets and to develop drugs to treat the disease. Using information about the human genome to develop drugs is called pharmacogenomics.
Normal cells can also be compared to cells that have been treated with a specific compound, to determine if that compound has a toxic effect on cells. Using information about how gene expression patterns vary when chemicals are toxic to tissues is called toxicogenomics.
The amount of information that is generated from sequencing three billion base pairs of DNA and using microarrays to look at gene expression patterns in tens of thousands of biological tissues and processes could not be stored and analyzed if it were not for advances in information technology that occurred with the development of computers and the internet. The science of using computers to capture and understand biology is known as bioinformatics.
Besides gene expression data, there are other methods to look at biological function. In addition to the traditional methods, new methods are being developed. Some of these include:
Gene expression and other methods of looking at biological functions are critical to pharmaceutical companies’ drug development processes. The current model for drug development is based on developing a systematic understanding of biology. Pharmaceutical companies develop drugs by seeking specific proteins that could be therapeutic targets. These companies then seek chemical compounds that could modulate or manipulate the targets in a way that would have a therapeutic effect. Scientists have the ability to screen large libraries of compounds using high-throughput automated systems against biological targets to identify potential therapeutic compounds that will modulate these targets. But, first, scientists must identify the targets, from among the 3,000 to 5,000 human genes that might produce proteins. One efficient way to identify these targets is using gene expression data produced from normal and diseased human tissues as well as from animal models and cell lines.
Molecular Diagnostics encompass a variety of technologies and methods for utilizing profiles of DNA and RNA changes in individual patients to facilitate determining what condition a patient has (diagnosis), the likely outcome (prognosis), response to therapy (monitoring), and the best responders to various treatments (personalized medicine). Traditional clinical diagnostic processes involve physicians analyzing patient body fluids or tissues to assess biological functions, usually by analysis of proteins and tissues. Over the past few years, the growth of molecular diagnostics has increased the use of RNA and DNA analysis to assess biological function.
Development of new types of molecular markers requires a process of discovery followed by validation in carefully selected patient populations in carefully controlled clinical trials. Such clinical trials may take weeks or years to conduct and results are generally published in peer-reviewed medical journals. Once enough studies are conducted to demonstrate the validity of a new diagnostic, the tests can be offered through laboratories licensed through a state and federal process certified by the Clinical Laboratory Improvement Advisory Committee (“CLIA”). Alternatively, manufacturers of the reagents and systems that are required to perform the diagnostic assay can submit an application to the FDA (510K or PMA) which, if approved, allows them to market products to laboratories and doctors who are licensed to conduct clinical analysis on tests ordered by doctors. In 2007, the FDA published draft recommendations suggesting new regulations on any genetic test that utilizes multiple markers and requires an algorithm to produce a result. While these draft recommendations have not been finalized, if they are, then the FDA would require approval for all tests in this category.
We currently conduct our operations through two business segments: the Drug Repositioning Division and the Genomics Division. We are focusing primarily on our Drug Repositioning business and continue to serve new and existing Genomics customers while seeking strategic alternatives for that business.
Drug Repositioning Division
Gene Logic’s drug repositioning platform provides an efficient and cost-effective approach for systematically uncovering a drug candidate’s biological activity and identifying possible new indications for drug candidates for which development has otherwise been discontinued.
The pharmaceutical development process is expensive, time-consuming and risky, with a high failure rate. See “Scientific and Industry Background” above. Billions of dollars are spent annually to identify and develop biologically active compounds that do not ultimately succeed for various reasons, including (i) insufficient effectiveness in treating the disease or condition for which they were designed; (ii) safety and toxicity issues; (iii) patient variability in responding to a drug candidate; and (iv) insufficient potential economic return for the company developing the drug candidate.
Pharmaceutical companies have traditionally relied on two mainstream approaches to establish a product pipeline - internal development and product in-licensing. The first approach continues to be time-consuming and expensive while the latter is limited by increased competition between pharmaceutical companies to in-license a finite number of quality drug candidates. Furthermore, in traditional drug development, development of a drug candidate that is determined to have limited effectiveness in human clinical trials for a selected indication will be stopped, even though the compound could be effective in treating other medical conditions. Until now, any alternative uses were most often discovered by serendipity, such as in the cases of Pfizer’s Viagra®, Eli Lilly & Co.’s Evista®, and Abbott’s Hytrin®.
Drug repositioning offers pharmaceutical companies a third approach to expanding their drug development pipelines. Gene Logic has the ability to evaluate a drug candidate in less than one year using our drug indication discovery platform, allowing us to quickly and efficiently discover possible new indications for a drug candidate. Following confirmation of the potential new use via in vivo efficacy tests, we believe that some of these candidates will be found suitable for re-entry into clinical development for a new indication. Our Drug Repositioning Division uses a technology platform that integrates technologies acquired from Millennium Pharmaceuticals in 2004 (which we continue to improve) with our core genomic and toxicogenomic capabilities (see below).
We have developed partnerships with four pharmaceutical partners in 2005 and 2006, Pfizer, Inc., F. Hoffmann-La Roche Ltd, Eli Lilly and Co., and NV Organon. Our agreement with Organon involves co-ownership and co-development of repositioned drug candidates, and it therefore differs substantially from our other agreements. Our other drug repositioning and development agreements vary somewhat as to specific terms (see “Contractual Arrangements” earlier), but generally conform to the following:
In most cases, if our partner decides not to take the drug candidate back into development, we have development rights that would entitle our partner to receive milestone payments and royalties on sales. We may choose to license such candidates to a third party for development, or we may invest in further development to increase a particular candidate’s value prior to outlicensing. We have acquired certain rights from Millennium Pharmaceuticals to a drug candidate for which we have identified potential new indications.
We believe that no single technology is adequate to assess the effect of a drug candidate across complex biological processes. Our multi-platform solution allows us to systematically and efficiently evaluate a range of biological activity that potentially may be affected by a drug candidate, including its potential effect on a wide variety of diseases, without requiring a prior disease-specific hypothesis. The technologies we use to develop hypotheses about which diseases a drug candidate may be used to treat include in vivo (in life), in vitro (in dish), in silico (in computer data), and ex vivo (outside organism) assessments of a drug candidate at the DNA, RNA, protein, pathway, and cellular levels.
The technologies include:
Real-Time In Vivo Imaging - We are using in-licensed technology in conjunction with proprietary protocols and procedures to create an optimal imaging program that allows the pharmacological action of a compound in organs and tissues to be visualized non-invasively using genetically engineered mice. This technology allows us to determine which organs are affected by the compound, timing of the response, and biological pathway information.
Ex Vivo Multiplex Bioanalytics - Using sophisticated laboratory automation and proprietary targeted separation and analysis techniques, we can simultaneously measure levels of biomolecules in certain biological fluids collected from a compound-treated animal. By comparing the levels of biomolecules in treated animals to those in normal animals, we can identify activity caused by the compound which may signal potential alternative disease indications.
In Vitro Molecular Pharmacology - Powered by sophisticated robotics and software, part of our technology platform allows us to apply a compound to a large number of cell types to identify pathways that may be activated or repressed by the compound. Another technology enables us to apply a compound to cells in a broad panel of cellular assays, each of which represents one or more relevant diseases, to measure the effect of the compound on the diseases.
In Silico Biology - Our existing genomics capabilities enable us to find close relatives of the target protein in the genome, major and minor sites of expression of the target in the body, disease conditions that alter the expression of the target, and a host of additional drug target parameters. We use the BioExpress® System and our proprietary algorithms and biostatistical expertise to identify pathways and cell regulatory patterns to understand a compound’s mechanism of activity in any organ of interest.
Potential alternative therapeutic uses can then be validated through a study, using an animal model related to the new disease indication, performed either in our laboratories or those of a third-party service provider or by our pharmaceutical partners.
In 2006, we began evaluating more than 40 drug candidates for our drug development partners. Based on our experience to date, we have a success rate of 25%-33% in developing new hypotheses. Some of these candidates for which we have found new indications have or will progress to in vivo efficacy models to evaluate and support their suitability for re-entering clinical trials for the proposed new indications. For the candidates that will shortly begin in vivo efficacy studies, our partners have agreed to fund a portion of the costs associated with these studies. We expect that some portion of the drug candidates will have successful outcomes in the in vivo tests and re-enter clinical trials, but we do not yet have sufficient data to estimate the rate of clinical trial re-entry. We do not expect any of these drug candidates to re-enter clinical trials, and we do not expect to derive significant revenue from milestones or royalties from our drug development partnerships, until after 2007.
Our Genomics Division includes proprietary gene expression and toxicogenomics databases, toxicogenomics services, software tools, microarray data generation and analysis services (for gene expression and SNP genotyping), and other professional services. These services assist researchers in identifying and characterizing drug targets and biomarkers and can help predict potential human toxicity of drug candidates. Gene expression patterns and biological pathways in disease, genetic abnormalities, and mechanisms involved in drug efficacy and toxicity all help researchers make better informed decisions.
Our genomics data are based on gene expression results and clinical data from a collection of over 35,000 diseased and normal human and animal model tissues, as well as primary cells and cell cultures. These samples, together with relevant pathology and clinical data are collected from clinical centers, teaching hospitals, academic medical centers, standard toxicology animal lab studies and, in some instances, commercial providers. The samples in our BioExpress System represent more than 400 separate clinical disease indications with focused collection programs in critical therapeutic areas of greatest market interest, including oncology, cardiovascular, central nervous system, inflammatory and metabolic diseases. The samples in our ToxExpress® System are primarily derived from animal liver, the primary toxicity response site, as well as animal heart and kidney.
We isolate and prepare the genetic material from these tissue samples and then analyze the genetic material through a high throughput, automated process using microarrays to determine gene expression. The results of this analysis and the corresponding pathology and clinical or experimental information for each sample are compiled using our software and bioinformatics capabilities, resulting in reference databases and software tools that are the foundation of our Genomics Division.
Our Genomics Division currently offers the following services:
BioExpress System and Related Products and Services - The BioExpress System is a database that enables drug development researchers to use our data to: (i) investigate human disease and disease progression by identifying and prioritizing disease-associated gene targets through an understanding of gene expression patterns, genetic abnormalities, disease pathways and disease mechanisms of action, (ii) examine the interrelationship between the human genome, disease mechanisms and related individual clinical parameters, and (iii) identify potential disease biomarkers. The database comprises gene expression data derived from normal and diseased human and animal tissues and related pathology and clinical or experimental information about those samples. BioExpress Suites and Custom Suites consist of subsets of BioExpress System data. The ASCENTA® System is a Web-based analysis system that contains selected, curated gene expression data sets from the BioExpress System.
Microarray Data Generation and Analysis Services - We offer a growing portfolio of services that enable customers to outsource to us the generation and analysis of gene expression and SNP genotyping information, primarily from customer-supplied biological samples. Our services are designed to deliver high quality, reproducible data in the customer’s preferred format. To provide these services, we use automation, state-of-the-art facilities and our expertise in sample handling, preparation and processing and data analysis. Customers use this information to help make better decisions throughout their drug discovery and development process.
ToxExpress System and Related Services - The ToxExpress System is a database consisting of gene expression profiles and associated experimental data from rat and canine tissues as well as rat and human primary hepatocytes. These samples include both normal samples and treated samples (i.e., samples that have been exposed to specific compounds with known toxicity). The information for each treated sample includes a “toxicity profile”, containing time-course, dose and other classical toxicology study information, supplemented with data from studies on primary human liver tissues and cells and other animal model tissues. The ToxExpress System data can be used to develop predictive models and to undertake mechanistic studies on acute and chronic human toxicity. Customers compare our data to theirs to develop risk assessment/management strategies, and to prioritize leads in development. ToxExpress also includes the following related offerings: ToxSuite Datasets, Molecular Mechanism of Toxicity Services, ToxShieldTM Suites, and Custom ToxExpress Services.
Genesis Enterprise System® Software - The Genesis Enterprise System Software is our enterprise-wide bioinformatics solution. It is a sophisticated and comprehensive software platform for warehousing, comparing, mining, analyzing and visualizing gene expression and clinical information. This software enables drug development researchers to compile and rapidly assess large data sets (including our proprietary data, customer-derived data and publicly available research data), and contains various tools for conducting sophisticated analyses of gene expression data.
In 2006, in response to our customers’ shifting their research activities from early-stage drug discovery into later-stage development and validation efforts, we examined our Genomics Division for new avenues to create value. We concluded that our commercially demonstrated expertise in biomarker discovery and validation could be used as a potential new platform for molecular diagnostics development. We believe that the following capabilities could serve as the basis for more rapid development of biomarker diagnostic products: (i) our substantial clinical network of hospitals and other research institutions with which we have agreements for human sample accrual; (ii) our Biorepository containing more than 17,000 human clinical samples from more than 400 different diseases; (iii) our BioExpress database and related software enabling biomarker prototyping, proof of concept, and specificity testing; and (iv) our GLP data generation capacity to undertake clinical validation studies. As a result, we have engaged outside financial advisors to identify strategic alternatives for our Genomics business. We continue to serve new and existing Genomics customers while we explore this opportunity.
CUSTOMERS, SALES, MARKETING AND CUSTOMER SUPPORT
During 2006, three Genomics Division customers each accounted for 10% or more of our total revenue.
The following table sets forth information on the composition of our total revenue by geographic region for each of the last three fiscal years:
We market and sell the services of our Genomics Division primarily to pharmaceutical and biotechnology companies based in North America, Japan and Europe. A company in Japan assists us, for a fee, in making sales in Japan and provides marketing advice and support in connection with our Genomics Division. We also maintain customer service support representation in Japan and the United Kingdom. We provide pre- and post-sales support activities to our Genomics customers through our genomics services and software support group, including technical demonstrations, planning and implementation of initial deployment and new and ongoing training, content updates, software upgrades, on-going support and follow-on training.
We market and sell the capabilities of our Drug Repositioning Division to pharmaceutical companies based in North America, Japan and Europe. We have a team of business development professionals with diverse pharmaceutical and consulting experience who lead contract negotiations with potential pharmaceutical partners. Once a contract is signed, members of both the technology and business development groups interact with each pharmaceutical partner as required.
RESEARCH & DEVELOPMENT
Research and development expenses for the years ended 2006, 2005 and 2004 were $9.9 million, $6.8 million and $2.4 million, respectively. Most of our research and development expenses consist of costs associated with our Drug Repositioning Division and are for the evaluation of customer-supplied drug candidates and ongoing development of our drug indication discovery platform.
A smaller portion of our research and development expense consists of general technology and process improvements related to our Genomics Division. This portion of our research and development is focused on developing new applications and licensing or acquiring technologies to serve as platforms for molecular diagnostics, and for the development of new gene expression, SNP genotyping, and other molecular-based solutions. We continue to research methods to improve the production of our gene expression data and decrease the size requirements for tissue samples.
Drug Repositioning Division
We have drug development partnerships to identify new indications for discontinued clinical-stage drug candidates from our pharmaceutical partners. Under these agreements, we do not receive up-front revenue. We are entitled to receive milestone payments in the event that a drug candidate for which we have found a new indication is returned to a partners’ development pipeline at its election. If our partner begins commercial sales of the repositioned drug, we would be entitled to a percentage of royalties based on actual sales or other compensation. Each partner has agreed to provide a specific number of drug candidates during the term of the applicable agreement, from which we can select those to be introduced into our drug repositioning pipeline. We will evaluate those drug candidates at our expense and will inform our partners of any new possible indications we identify for these drug candidates. In some instances, our partners have the right to elect to have us conduct mutually agreed upon in vivo model validation studies based on our hypotheses, which may be partially or entirely at our or our partners’ expense. Drug candidates with new indications would then be returned to a partner’s pipeline at its sole election. If a partner elects not to pursue a new use we identify, we may, in some instances, have the option to develop, license and commercialize such use, subject to payments of success-based milestones and royalties to our partner. Unlike our other agreements, under the agreement with Organon, both companies are equal owners of drug candidates for which we find new uses and may decide to jointly develop and commercialize the drug candidate. If we acquire development rights as to a given drug candidate, we could elect to either (i) out-license the development rights to such drug candidate without further development on our part, or (ii) continue to develop the drug candidate, either through our own resources or with a development partner, to a point where we can more effectively out-license the drug candidate to a third-party for final development and commercialization.
We do not expect to derive any significant revenue from milestones or royalties under these agreements until after 2007.
We expect that approximately half of our Genomics Division revenue in 2007 will continue to be derived from subscription agreements. Our customers enter into multi-year or perpetual license agreements for our larger databases (and annual, multi-year, or perpetual license agreements for certain of our smaller databases) to obtain non-exclusive access to all or parts of our gene expression and toxicogenomics databases. These agreements may be for a full database or a portion of a database tailored to a customer’s needs and most relevant to their drug development strategy. One of our subscription agreements contains requirements for the addition of certain data that, if not met, could result in a reduction in license fees. Pricing for these subscriptions is generally dependent upon such factors as the database solution being offered, the term of the license, the extent and type of use by the customer, the number of users at the customer site, the scope of installation at the customer’s site, requirements for customization, any content requirements and whether we provide any custom analysis or data management services. Contracts under these subscription agreements may be terminated by either party if the other party breaches the agreement and fails to cure such breach within any applicable cure period or in the event of a bankruptcy of either party.
In certain circumstances, customers may acquire a perpetual license to use certain information from our databases. Pricing for perpetual licenses to data is generally dependent upon such factors as the data solution being offered, the extent and type of use by the customer and the number of users at the customer site. Some of our customers purchasing perpetual licenses continue as customers purchasing additional services, including licenses to other databases and microarray data generation and analysis services.
We expect that approximately half of our revenue will be derived from a combination of microarray data generation and analysis and other professional services and solutions. The particular type and scope of the services we provide are based on the customer’s needs. Pricing for these services is generally dependent upon such factors as the number of samples or compounds analyzed, the type of analysis performed, the starting material provided by the customer, the type and source of GeneChip® microarray used for the services and requirements for customization. Generally, contracts for services may be terminated by either party if the other party breaches the agreement and fails to cure such breach within any applicable cure period or in the event of a bankruptcy of either party.
Drug Repositioning Division
Currently, an increasing number of pharmaceutical and biotechnology companies are evaluating whether to implement internal repositioning programs for their own drug candidates. In addition, there are companies attempting to reposition drug candidates on behalf of drug development partners, including Melior, KineMed, Perlegen Sciences, Inc., Vanda Pharmaceuticals Inc. and CombinatoRX Inc. We are not aware of any existing competitor that has developed, or is in the process of developing, a comparable suite of technologies to that employed by us. Other companies, some of whom are not doing repositioning work, have individual technologies that could directly compete with components of our drug repositioning technology platform.
Our Genomics Division competes with internal capabilities of pharmaceutical and biotechnology companies and universities worldwide which may choose to use genomics technologies to generate for their own use similar sets of gene expression or SNP data. To a lesser extent, we also compete with commercial providers who offer less extensive and, in at least one instance, population-specific data (deCODE genetics, Inc.). In addition, at least one privately held company that we know of (Iconix Pharmaceuticals, Inc.) licenses an alternative toxicogenomics database and provides predictive toxicogenomics services that compete with our toxicogenomics services. In addition, we face increasing competition from a variety of public and private companies in the area of microarray data generation and analysis services, including Expression Analysis, Inc. and Clinical Data, Inc. However, we currently believe there are no commercially available gene expression databases of comparable size and scale to that of our BioExpress and ToxExpress System databases. Our services compete on the basis of: scope and quality of services offered; price; speed of delivery of specific services; strength of reputation; size of our databases; alternative technologies; expertise and experience in specific technological and scientific areas; subject focus of genomics and toxicogenomics data sets and technologies; our ability to acquire, handle, process, store, analyze and present complex gene expression data and clinical annotation information in a timely, quality controlled and accurate manner; and, our ability to integrate proprietary gene expression data with publicly available and other third-party generated data sets.
Drug Repositioning Division
In our Drug Repositioning Division, we have a non-exclusive license and sublicense from Promega Corporation (the “Promega License”) to use the luminescence technology we use in our real-time in vivo imaging. The term of the agreement is for the life of the relevant patents, unless earlier terminated upon breach by either party, bankruptcy or termination of Promega’s rights by an academic institution that holds certain rights to a portion of the technology (in which case we would seek separate licenses from Promega for its technology and directly from the institution). Under the terms of the agreement, we paid Promega an initial fee and we pay Promega an annual license maintenance fee and royalties on luminescent assay reagents we use that are not purchased from Promega. We also have a non-exclusive license with Xenogen Corporation (the “Xenogen License”), for which we pay an annual license fee to use the Xenogen Imaging Technology and certain related software in connection with our use of certain imaging equipment we purchased from Xenogen for use in performing real-time in vivo imaging. The term of the Xenogen license ends in 2008, with a three year renewal option, subject to earlier termination if we fail to make timely payment or otherwise breach the terms of the agreement, and we have agreed to indemnify Xenogen and certain other persons and entities for liability resulting from our use of the technology.
To build our genomics and toxicogenomics databases that are the basis of our Genomics Division, we enter into collaboration agreements from time to time with institutions or individuals (including a few commercial providers), to obtain specific tissues, blood samples and cell lines and associated experimental or clinical data. We pay fees under these agreements and, in the case of non-commercial providers, we may provide access to software and to certain gene expression data and financial support for the collaborator’s research. Non-commercial collaboration agreements typically have a term of two to three years, subject to automatic renewal unless earlier terminated by either party. Since we’ve already compiled a broad base of general data, our efforts are currently focused on the procurement of special, high-value, difficult-to-obtain and rare samples. We continue to believe that none of these collaboration agreements are individually material to our operations because any one can be replaced on comparable terms with another provider.
To generate the gene expression data in our genomics and toxicogenomics databases and to provide microarray data generation and analysis and other services and solutions as part of our Genomics Division, we use Affymetrix, Inc. (“Affymetrix”) microarrays, reagents, instrumentation and software. Our 2006 supply and license agreement with Affymetrix expired on December 31, 2006. On January 9, 2007, but effective January 1, 2007, we entered into (a) a new three-year Biotech Access Agreement governing our purchase and use of Affymetrix microarrays and related products for internal research and to generate data for databases and (b) a new two-year Service Provider Agreement governing the purchase and use by us of microarrays to provide data generation and analysis and other services and solutions to individual customers. Under terms of the new agreements, we are obligated to grant to Affymetrix a non-exclusive, royalty-free license to certain inventions we make related to their microarray technology and, under certain circumstances, to offer to negotiate with them a non-exclusive, royalty-bearing license for certain inventions we make related to sample processing. The Biotech Access Agreement requires payment of an annual access fee of $50,000, subject to waiver for any year in which we are an Affymetrix Service Provider, and sets prices for the products, reagents and instrumentation we purchase from Affymetrix. The Service Provider Agreement (but not the BioTech Access Agreement) is terminable by either party if the other party defaults under the agreement and, after written notice from the non-defaulting party, fails to cure the default during the applicable cure period.
In the past, we also purchased from Affymetrix a reagent made by Enzo BioChem, Inc. (“Enzo”). As first reported in 2004, in late 2003 Enzo terminated its distribution agreement with Affymetrix and filed suit against Affymetrix alleging in part that Affymetrix had agreements with us and other named customers to supply the reagent for use in potential violation of their rights. Subsequently, Affymetrix denied Enzo’s claims, filed counterclaims and also introduced a new alternative reagent, which we are using. The lawsuit is currently in the discovery and pretrial hearing stage.
INTELLECTUAL PROPERTY RIGHTS
As of December 31, 2006, in our Genomics Division, we have exclusive ownership or license rights to 58 issued patents, 26 of which are United States patents, and 98 patent applications, 47 of which are United States utility (non-provisional) or provisional patent applications. As of December 31, 2006, in our Drug Repositioning Division, we have exclusive ownership or license rights to 8 issued patents, all of which are United States patents, and 25 patent applications, 11 of which are United States utility (non-provisional) or provisional patent applications; except for one application, all of these patents and applications relate to either of two compounds or their potential uses. We do not at this time believe that any single patent or application is individually material to our business.
With respect to proprietary know-how and products and processes for which patents are of questionable value or are difficult or impossible to obtain or enforce, we rely on confidentiality agreements and other trade secret protection measures to protect our interests. We take security measures to protect our proprietary know-how and technologies and confidential data, including requiring all employees, consultants and customers to enter into confidentiality agreements. In arrangements with our customers or suppliers that require the sharing of processes and data, our policy is to make available only such data as is relevant to our agreements with such customers and suppliers, subject to appropriate contractual restrictions, including requirements for them to maintain confidentiality and use such processes and data solely for our benefit. However, such measures may not adequately protect our data.
In the areas of genomics, toxicogenomics and bioinformatics technologies related to these capabilities, we seek patent rights primarily to protect our freedom to operate, and to obtain whatever exclusivity may be available under a given patent that relates to our main service offerings. We apply for patent protection on methods of obtaining and using genomic information and on databases, software, and user interface tools relating to the management and use of such information. Our applications may also contain claims to methods of identifying and using gene expression profiles and genetic markers, claims to novel genes and gene fragments, and claims to novel uses for known genes or gene fragments. We also actively file patent applications on technologies and methodologies we have developed in the field of toxicogenomics. Our toxicogenomics patent applications contain claims that cover methods of predicting toxicity, toxicity markers, statistical models, and other inventions related to our toxicogenomics program.
We have a worldwide, nonexclusive, fully paid, non-transferable license for the life of certain patents from Incyte Corporation (“Incyte”) (formerly Incyte Genomics, Inc.), obtained in connection with the settlement of certain litigation in 2001, to use i) a process that Affymetrix recommends we use in the preparation of samples for use with the Affymetrix GeneChip platform; and ii) certain patent rights related to the development and use of certain types of databases. The samples and process may only be used to generate gene expression data for use in research and development. The license may be terminated by Incyte under certain limited circumstances if we: i) use certain patents outside of the permitted field of use, or induce another party to do so; ii) violate certain agreements regarding any future disputes between the parties involving these patents; or iii) violate the confidentiality provisions of the agreement. If Incyte were to terminate the license agreement on the grounds that we materially breached such agreement and if we dispute such claim, the party in whose favor the court finds would be entitled to an agreed-upon payment from the losing party. Likewise, if we claim Incyte has materially breached the License Agreement and if Incyte disputes such claim, the party in whose favor the court finds would be entitled to an agreed-upon payment from the losing party.
Under the terms of our supply agreement with Affymetrix described above under “Suppliers,” we have the right to use Affymetrix products, software, systems and database patent rights to generate and use databases, license the data in such databases to third parties and provide sample processing services to generate and analyze data for a customer’s internal use for research and development. In addition, we are obligated to grant to Affymetrix a non-exclusive, royalty-free license to certain inventions we make related to their microarray technology and, under certain circumstances, to offer to negotiate with them a non-exclusive, royalty-bearing license for certain inventions we make related to sample processing.
For our Drug Repositioning Division, we have acquired or obtained licenses to use certain intellectual property rights and technologies from Millennium, Xenogen, Promega and others, and we will, from time to time, continue to acquire and obtain licenses to use intellectual property rights and technologies as needed for our Drug Repositioning Division. We will also pursue patents, where appropriate, on new enabling technology used in our Drug Repositioning Division. Certain agreements with partners having rights to known drugs, under which our Drug Repositioning Division seeks new therapeutic uses for such compounds, provide us with certain intellectual property rights to those new uses. Where such agreements permit, we will pursue broad patent protection for selected new uses that we have found for known drugs.
Drug Repositioning Division
Our Drug Repositioning Division operations in our Cambridge, Massachusetts facilities are subject to a variety of national, state and local laws and regulations, including the Animal Welfare Act and the rules and regulations promulgated thereunder by the United States Department of Agriculture (“USDA”). These regulations establish the standards for the humane treatment, care, use and handling of animals by research facilities. In addition, our Cambridge facilities are registered with the United States National Institutes of Health Office of Protection for Research Risks (“OPRR”) and comply with The Office of Laboratory Animal Welfare (“OLAW”) regulations. Our Cambridge, Mass. facilities maintain standard operating procedures and the documentation necessary to comply with such regulations. Our Cambridge, facility is subject to regulation under the Ordinance for the use of Laboratory Animals for the City of Cambridge which is enforced by the Commissioner of Laboratory Animals. Under this ordinance we maintain standard operating procedures and the documentation necessary to comply with such regulations.
Our Genomics Division depends upon our continued access to and use of tissue samples and related clinical data, which are affected by regulations governing disclosure of confidential personal data, such as regulations governing the disclosure of medical information, issued by the Department of Health and Human Services under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”), and applicable regulations of Canada and the European Union. We monitor our procedures to ensure that such procedures comply with applicable privacy regulations. We also perform certain experiments in our Genomics Division which comply with applicable laboratory standards as prescribed by the Good Laboratory Practice (“GLP”) regulations promulgated by the FDA. The acquisition and use of human tissue by us is generally subject to regulations imposed by the Internal Review Boards of the organizations providing such materials and to the requirements for patient informed consent.
All of our laboratories are subject to licensing and regulation under federal, state and local laws relating to hazard communication and employee right-to-know regulations, the handling, storage and disposal of medical specimens, laboratory materials and hazardous waste and radioactive materials and the safety and health of laboratory employees.
The Occupational Safety and Health Administration (“OSHA”) has established extensive requirements relating to workplace safety, which require us follow certain procedures including providing ongoing training and proper equipment for employees working in our facilities. Our employees receive initial and periodic training focusing on compliance with applicable hazardous materials regulations and health and safety guidelines.
The use of controlled substances in our laboratory testing facilities is regulated in the United States by the United States Drug Enforcement Administration (“DEA”) and relevant state and local agencies. All of our laboratories using controlled substances for testing purposes are subject to licensure by the DEA and applicable state agencies.
The regulations of the United States Department of Transportation and the United States Postal Service apply to the transportation of laboratory specimens via surface and air.
Customer purchasing patterns do not show significant predictable seasonal variation.
As of December 31, 2006, we had 151 employees, consisting of 150 within the United States, and 1 who resides in Japan. Most of our employees are engaged directly in research, development, production and marketing and sales activities. None of our employees are covered by collective bargaining agreements, and management considers relations with our employees to be good.
We maintain a Web site at www.genelogic.com. However, material contained on our Internet site is not incorporated by reference into this Form 10-K. We make available free of charge on or through our Web site our SEC filings, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports we file or furnish pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission (SEC).
We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. Set forth below are risks and uncertainties we have identified as material that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Form 10-K and that could have material adverse effects on our business, results of operations, financial condition and cash flows.
Risks Related to Our Drug Repositioning Division
Our platform may not yield sufficient new indications and thus measurable successes to gain market acceptance.
We may not succeed in achieving significant market acceptance of any of our technologies used in drug repositioning activities because the technologies we use and our approach to drug repositioning may fail to generate sufficient new indications that are accepted for clinical trial re-entry or that are of sufficient commercial value to interest our partners. This outcome would have a material adverse effect on our business, financial condition, results of operations and market valuation.
Others are developing and could provide drug repositioning research and services that could compete with us and jeopardize our business and financial objectives.
Pharmaceutical companies and other companies and research organizations are developing technologies for better understanding the complex biological processes affected by compounds and selecting, purposing and repurposing compounds. These parties may elect to use such technologies internally, in lieu of using our services, or may successfully offer such services based on their technologies in competition against us. While we have license rights related to certain of the technologies that comprise the technology platform for our Drug Repositioning Division, we do not currently have issued patents to any of the technologies we use other than our genomics databases and software and our license rights to the other technologies are generally non-exclusive. We will seek patents or other protection on other elements of the technologies we use to find new indications for drug candidates. We may not be able to obtain adequate protection for these technologies or the technologies may become obsolete. Competition for our services could cause us to be unable to get sufficient compounds to achieve our business objectives, and could otherwise jeopardize our ability to achieve our financial objectives, in drug development.
The time required to present and negotiate our drug repositioning agreements is lengthy; we may spend considerable resources on unsuccessful sales efforts or may not be able to negotiate and enter into drug development partnership agreements on the schedule we anticipate.
Our drug development business strategy depends upon our ability to establish collaborative arrangements with pharmaceutical partners to reposition candidates that have been assessed as safe in human clinical trials but for which development for the original indication has been discontinued. If we are unable to establish partnerships with a sufficient number of pharmaceutical companies, we may not be able to obtain enough drug candidates to meet our business objectives.
Our ability to obtain new drug development partnerships depends upon our ability to convince them that our drug indication discovery platform can increase productivity for their drug development efforts. Intentional repurposing of candidates is a relatively new activity. Pharmaceutical companies need to be persuaded of the potential of this approach. In addition, pharmaceutical companies do not generally have specific individuals responsible for managing discontinued candidates. The time required to present our proposals for drug repositioning and negotiate agreements is substantial (often 12 months or more) and we may expend substantial effort with no assurance that a new agreement will result on terms acceptable to us or that provide sufficient opportunities for us. Consolidations of pharmaceutical and biotechnology companies could also affect the timing and progress of our Drug Repositioning Division sales efforts.
We may be unable to obtain access to sufficient numbers of acceptable candidates for evaluation by our platform to meet our business objectives
Our business plan is dependent on having sufficient acceptable compounds available to evaluate, to provide us with sufficient opportunities to find compounds with alternative indications that are appealing to our partners or to us for further development. At present, we can only obtain access to these compounds through our partners. There are challenges to obtaining new drug development partnership agreements, as described above. Further, even after we enter into an agreement with a partner, it may take time for that partner to identify acceptable candidates it is willing to make available to us which may further limit the numbers, or timely availability, of compounds we can use to meet our business and financial objectives. At present, while we have the capacity to evaluate greater numbers of compounds, such compounds are not available under existing agreements. Our achievement of our business objectives will continue to be limited by the numbers of acceptable candidate compounds available for evaluation for alternative indications.
We may be required to invest significant resources in identifying alternative uses for our partners’ candidates. We will not receive any revenue from our partners unless they decide to return candidates to their pipeline and our ability to earn revenue under our drug development agreements is based in part on factors over which we may have little or no control.
Under our drug development partnership agreements we typically have agreed to perform evaluations of candidates at our expense. Accordingly, we may need to invest significant resources in seeking alternative uses for one or more partners’ drug candidates using our drug indication discovery platform, and we may find no new or alternative uses for these candidates. If we identify new or alternative uses for a given candidate, we may not be able to realize any value from the identification of such alternative use until our partner determines, if ever, that the use makes the candidate sufficiently desirable to warrant further development and commercialization. We do not control when, on what schedule, or whether, a partner will accept a drug candidate for redevelopment or at what pace, if at all, the partner will conduct further development efforts of such repositioned drug candidate. Such decisions may be affected by factors of which we may not be aware and over which we will have no influence.
In the event that a partner declined to develop a candidate for an indication we had found, we could, in some instances and with the agreement of our partner, acquire rights to develop that candidate for particular indications and, if we were to elect to pursue development of any such candidate, any such development would require that we promptly find a partner and/or that we invest substantial financial and other resources to develop the product to a stage where we could license it out to a third-party for final development and commercialization. We have not engaged in drug development to date and there can be no assurance that we would be successful in conducting such development or in identifying a licensing partner to continue such development on terms that would be profitable to us.
If we find new uses for candidates, we may not realize sufficient return from such discoveries. The indications we find may not be sufficiently attractive for development by our partners or us due to factors such as: difficulties in obtaining adequate patent protection for the new indication, the existence or discovery of alternate drug candidates that may equally or more effectively address the therapeutic need or the internal requirements of our pharmaceutical partners. Even if a candidate reenters a partner's pipeline, our milestone revenue depends on whether further development of the candidate is successful and our royalty revenue will depend on whether the candidate is commercially successful, all of which is outside of our control.
These factors may limit our ability to earn significant revenue under any of our agreements.
The drug indication discovery platform for our Drug Repositioning Division currently relies in part on inventions of third parties that may not always be available to us.
Our drug indication discovery platform currently relies in part on inventions to which third parties have obtained or are obtaining patent or other rights and, in the process of further developing the platform we may need to license rights to use other such inventions. We may not be able to retain or to obtain license rights needed for one or more of these technologies on terms acceptable to us. We currently license certain technology in connection with certain products purchased from Xenogen Corporation and we also purchase and license the right to use Luciferase from Promega Corporation. The Xenogen license is for a term ending in 2008 with an option to renew for an additional three years. The Promega license is for a period ending on the expiration or abandonment of the last of the valid claims of the licensed patent rights. Each of these licenses is terminable if we breach the agreement and fail to cure such breach within the applicable cure period. In addition, the Promega license includes a sublicense to rights owned by an academic institution and the license from Promega would terminate if the license to Promega from the academic institution terminated. If either of these agreements were to terminate while the relevant patent claims were enforceable and if we were not able to obtain new licenses, we would have to abandon or substantially revise one of the key technologies used in our drug repositioning process.
Risks Related to Our Genomics Division
The Genomics Division is currently our sole source of revenue and, to continue to derive revenue from this division in the short term and to achieve our strategic objectives, we need to maintain the existing business.
While we seek new uses for our Genomics assets, our strategy depends, in part, on maintaining revenue from and controlling costs in our Genomics Division. To maintain revenue, we must extend existing subscriptions, find new subscribers and obtain new orders from existing customers and find new customers for our data generation and other services. All of our remaining long-term subscriptions are due to expire by their terms in 2008 and there is no assurance that any of them will be renewed or extended. While we currently expect to continue to reduce our dependence on large, multi-year subscription agreements, and increase revenue from data generation services, if we fail to achieve our revenue objectives, our Genomics Division segment could experience further losses, which also could have an adverse effect on our ability to develop an alternative strategy for the Genomics assets and our entire business could materially suffer. It is also possible that we could eventually be forced to further reduce the size of our business or to further dispose of some or all of the Genomics assets.
We may not be able to identify or implement a business strategy that will achieve our objectives.
While we believe that our expertise in biomarker discovery and validation could be used as a potential new platform for molecular diagnostics development and we have engaged outside financial advisors who are actively assisting us in determining the value of our competencies and assets in this area, it is possible that we will be unable to identify a strategic alternative that would provide significant value from the further development of these assets. Further, in the process of determining the long-term prospects and value of the business, we may conclude that the fair value of the Genomics business is less than its carrying value, which may require us to take one or more impairment charges.
As a result of uncertainty about our long-term Genomics business strategy and as a result of restructuring our operations, we may have difficulty attracting and retaining customers and employees.
We have significantly restructured our Genomics Division to reduce future operating expenses and have changed the strategic focus of the Company. We are also contemplating strategic alternatives that could have a material impact on our business as it is presently conducted, none of which may be successful. These factors create uncertainty, which could cause customers and employees to have concerns about our future or, in the case of employees, their future, and they may be hesitant to commit to a long-term relationship with us and existing employees may be distracted from their job responsibilities and seek other employment. We may also find it difficult to recruit new employees due to uncertainty over our future. If customers do not believe that we will continue to support, enhance or update our services, they could be less willing to purchase those services. While we believe our personnel reductions have targeted areas not necessary to our ability to serve customers, there can be no assurance that these changes will not have a negative impact on our ability to keep retained staff or provide adequate services to our customers, which, in turn, may have an adverse impact on our ability to retain and hire employees and to retain existing customers and obtain new customers.
Our genomics and toxicogenomics databases may require upgrading and expansion to keep existing and find new customers, but such upgrading and expansion may be difficult or expensive.
In the past, we have invested in new database content, upgraded our databases and developed new versions of our software tools due to customer demand and changes in the microarray platforms. In recent years we have reduced the amount of content added each year to our database and focused on data from samples of particular interest to our customers. Specific tissue and blood samples that we believe will enhance the content of our databases may be difficult to obtain or may not be available on terms acceptable to us. Future investments will be limited as we continue the transformation of Gene Logic into a biopharmaceutical company. However, if we choose not to make such changes, it could affect our ability to keep existing or find new customers.
The sales cycle for our Genomics Division is lengthy; we may spend considerable resources on unsuccessful sales efforts or may not be able to complete deals on the schedule we anticipate.
The sales cycle for multi-year subscriptions to our BioExpress and ToxExpress System databases is estimated at nine to 15 months; the sales cycle for our other services, including toxicogenomics reports, microarray data generation and analysis and other professional services and solutions requires at least several months. The lengthy sales cycle is caused by a number of factors, including our need to educate our existing and potential customers and sell the benefits of the services of our Genomics Division to a variety of groups within such companies and the possible negotiation of unique terms. We may expend substantial effort with no assurance that a new or extended subscription or other agreement will result or that it can be completed in a timely manner. Actual and proposed consolidations of pharmaceutical and biotechnology companies have affected, and may in the future affect, our Genomics Division sales efforts.
We rely on microarrays and other products supplied by Affymetrix to maintain and add to the underlying genomics and toxicogenomics data of our databases and to provide our microarray data generation and analysis and other services.
Our continuing ability to maintain and add to the gene expression data that is the foundation of our databases depends in part on the ability of Affymetrix to supply us with adequate quantities of high quality microarrays and other products and to make available licenses of technologies to use such products. We also rely on Affymetrix microarrays to provide our microarray data generation and analysis services and on a new line of SNP-based microarrays to provide our SNP genotyping services. Affymetrix provides us with microarrays, reagents, instrumentation and software under two agreements that expire on December 31, 2008 and 2009 respectively. There is no assurance that we can renew such agreements on terms comparable to, or as favorable to us as, the current agreements. One of the agreements is also specifically terminable if we breach the agreement and fail to cure any breach within the applicable cure period. If Affymetrix is unable or unwilling to supply us with the products and licenses we require on acceptable terms or if the microarrays are unavailable or defective or otherwise unreliable, we may incur additional database production costs and we may need to obtain alternative technologies. Alternative technologies may not be available to us, or may only be available to us on unfavorable terms. Restricted or curtailed access to such products could cause our Genomics Division to suffer by preventing or delaying our ability to provide our databases and services or increasing the cost to generate additional or replacement content for our databases.
We have a history of operating losses that are likely to continue for some time.
We have incurred operating losses in each year since our inception, including losses of $54.7 million in 2006, $48.3 million in 2005, and $28.5 million in 2004. At December 31, 2006, we had an accumulated deficit of $315.7 million. Our losses have resulted principally from costs incurred in the development, marketing and sale of services from our Genomics and former Preclinical Divisions, development of the Drug Repositioning Division, the impairment of goodwill of our former Preclinical Division, and acquisitions of research and development. These costs have exceeded our revenue and we expect to incur additional losses in the future, including losses relating to the ongoing development of our Drug Repositioning Division.
Our ability to use our Federal Net Operating Loss carryforwards may be limited.
We intend to utilize our Federal Net Operating Loss carryforwards (“NOLs”) to reduce any potential future United States income tax liability. These NOLs begin to expire in 2008. Based on a Section 382 analysis performed in the fourth quarter of 2006 (that excluded NOLs obtained through acquisitions), we do not believe we are currently subject to any current material limitations on the use of our NOLs to offset our potential future income tax liability, although such limitations could occur in the future. However, we may not generate sufficient taxable income to utilize our NOLs prior to their expiration.
Our ability to retain and recruit and retain qualified personnel may be adversely affected by the substantial changes we are undergoing.
In 2006, we sold our Preclinical Division and restructured our Genomics workforce and supporting staff. We are now in the process of trying to develop new uses and find strategic alternatives for our Genomics assets and capabilities and continuing to develop our Drug Repositioning Business. These changes and the uncertainty of our future may make it difficult to retain and to recruit qualified personnel.
We may not be able to obtain necessary funding as required to develop and operate our Drug Repositioning Business and our Genomics Business.
We do not expect to begin to generate any significant revenue in our Drug Repositioning business until at least after 2007 and our Genomics business is currently operating at a loss. We are seeking strategic alternatives for our Genomics business to provide funding to develop the potential of this business for human molecular diagnostics. We may also need additional financing for our Drug Repositioning business. If we are unable to find an acceptable strategic alternative for our Genomics Division or to obtain necessary financing, or financing on favorable terms, when needed for our Drug Repositioning Division, our business would materially suffer. If additional financing is obtained through the issuance of equity securities or debt convertible to equity, our existing stockholders could experience significant dilution.
Our revenue is derived primarily from, and is subject to risks faced by, the pharmaceutical and biotechnology industries in the United States, Japan and Europe; our revenue is also subject to foreign currency risk.
We expect that our revenue will continue to be derived primarily from agreements with pharmaceutical and biotechnology companies. As a consequence, our results of operations may fluctuate substantially due to fluctuations or delays in our customers’ research and development expenditures and other factors affecting their purchasing decisions. These factors include:
In addition, beginning in 2005, contracts with our Japanese customers began to be payable in Japanese Yen and are subject to fluctuations due to changes in currency exchange rates.
None of these factors is within our control.
We sold our Preclinical Division in December 2006, but are still subject to certain risks from that sale.
In December 2006, we sold our Preclinical Division. Under the terms of that sale, there was to be a post-closing reconciliation of working capital that could result in a purchase price adjustment. In accordance with the terms of the agreement, the buyer has raised the possibility that an adjustment is required, requiring us to make an additional payment to the buyer. We are in the process of resolving the matter as provided in the agreement. In addition, $1.5 million of the purchase price was placed in escrow until December 15, 2007 to cover our potential liability for any breaches of our representations, warranties and agreements in the stock purchase agreement, including as to certain retained liabilities. Claims for breaches of warranty relating to payment of taxes and environmental and certain other matters can exceed the escrow amount. If we concluded that the buyer is entitled to a purchase price adjustment under the terms of the agreement or the buyer makes valid claims against the escrow fund or under other indemnification provisions in the purchase agreement that are not subject to the escrow fund limitations, we could experience further costs associated with the sale of the business and may be required to further adjust the impairment charge associated with the sale of the Preclinical Division.
We also guarantee two leases of facilities to our former Preclinical Division. Buyer is required to either substitute itself as guarantor or indemnify us for any claims made against our guarantees. If the former Preclinical Division defaults under such leases and claims are made against our guarantees and buyer fails to substitute itself as guarantor or adequately indemnify us, we could suffer additional losses.
Certain investments made by the Company may fluctuate in value and may create an adverse impact on our financial performance; the value of certain of our intangibles and long-term investments creates risk to our financial performance.
We’ve previously recorded value for goodwill and other intangible assets, including licenses to technologies or data, patent costs and software development and database upgrade costs which, at December 31, 2006, had an aggregate value of $12.7 million. Whether or not these intangible assets are impaired involves significant judgment, including the following: (i) whether our licenses and internally developed intellectual property may not provide valid and economical competitive advantage; and (ii) whether our services we provide may become obsolete before we recover the costs incurred in connection with their development. Under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”, we are required to perform periodic reviews of our intangible assets and we may be required to reduce the value of these assets if circumstances change.
In addition, we have an investment in Xceed Molecular (formerly named MetriGenix, Inc.) with a book value as of December 31, 2006 of $3.0 million. This investment is subject to periodic evaluation for impairment. Since Xceed is an independent company in which we are a minority stockholder, the factors affecting an impairment analysis, which include potential revenue, cost of capital and fair market value of the entity, are not within our control. There is no guarantee that, in the future, this investment might not be subject to an impairment charge.
We may not be able to obtain adequate patent protection for new technologies and methods required for achieving our business objectives.
Our success will depend in part on our ability to protect confidential information and to obtain intellectual property rights and licenses sufficient to provide adequate exclusivity and to preserve our freedom to operate.
We rely on confidentiality agreements and other trade secret protective measures to protect our interests in proprietary know-how and technology that are not patentable or for which patents are difficult to enforce. We have taken security measures to protect our proprietary know-how and confidential data and continue to explore further methods of protection. While we require all employees, consultants and customers with access to our trade secrets to enter into confidentiality agreements, we cannot be certain that we will be able to protect our trade secrets. We also rely on confidentiality procedures to prevent public disclosure of patentable proprietary technology prior to filing patents. Any material leak of confidential information into the public domain, or to third parties, could cause our business, financial condition and results of operations to suffer adverse consequences, including possible loss of patent rights.
Our patent position involves complex legal and factual questions. Legal standards relating to the validity and scope of claims in the genomics technology field are still evolving. Therefore, the degree of exclusivity that future patent protection may provide for our proprietary technologies in this field is uncertain. Likewise, legal standards relating to validity of claims to new methods of using known drugs are still evolving. Hence, the likelihood of patenting potential new therapeutic uses of drug repositioning candidates also is uncertain.
Specific risks and uncertainties that we face in the area of patent exclusivity include:
We may need to initiate patent enforcement litigation or be subject to future infringement claims.
In addition, other organizations, including companies, academic and non-profit institutions and governmental organizations are developing technologies in the genomics and drug repositioning fields. Many of these technologies are subject to the same evolving legal standards and related uncertainties about patent protection as our proprietary technologies. Therefore, it may be necessary for us to initiate litigation to protect and enforce our intellectual property rights.
We also face risks that patents issued to other organizations may restrict our ability to do business, and that we may be unable to obtain or maintain licenses providing freedom to operate on acceptable terms. Thus, the technologies that we use to develop our services, and those that we incorporate in our services, may be subject to claims that they infringe the patents or proprietary rights of others. In particular, we are aware of a number of patents and patent applications owned by others relating to genetic markers and to the analysis of gene expression or the manufacture and use of microarrays and related materials. Therefore, we could be sued by parties alleging patent infringement.
The risk of involvement in patent litigation may increase as the genomics, biotechnology and software industries and drug repositioning businesses expand, more patents are issued and other organizations engage in our business fields. We could incur substantial litigation costs to defend ourselves in patent infringement suits brought by other parties or to initiate such suits. In addition, patent litigation could cause disruption in our business activities and divert management’s time and attention from the operation of our business. In that regard, in the past we purchased reagents made by Enzo from Affymetrix, and also directly from Enzo. In late 2003, Enzo sued Affymetrix, alleging, among other things, that Affymetrix had agreements with Gene Logic and other named customers to supply the Enzo reagent for use by such customers in potential violation of Enzo’s rights. That suit continues, but we have not been made a party to that suit. It is possible that Enzo could in the future make claims or initiate litigation against us in connection with our prior use of their reagent.
Our activities involve hazardous materials and may subject us to environmental liability.
Certain activities of our businesses involve the controlled use of limited quantities of hazardous and radioactive materials and may generate biological and/or hazardous waste. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of these materials and certain waste products. Although we believe that our safety procedures for handling and disposing of these materials comply with prescribed standards, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of an accident or if we otherwise fail to comply with applicable regulations, we could lose our permits and/or approvals or be held liable for damages or penalized with fines.
We believe that we comply in all material respects with currently applicable environmental laws and regulations and do not expect near term material additional capital expenditures for environmental control facilities. However, we may have to incur significant costs in the future to comply with environmental laws and regulations. At present, we also believe we have appropriate insurance coverage against hazardous materials claims.
If we are unable to maintain compliance with NASDAQ’s listing requirements, our stock could be delisted which would negatively impact our liquidity and our stockholders’ ability to sell shares.
Our listing on the NASDAQ Global Market is conditioned upon our continued compliance with the NASDAQ Marketplace Rules, including a rule that requires that the minimum bid price per share for our common stock not be less than $1.00 for 30 consecutive trading days. Given the recent price levels for our common stock, we cannot assure that we will be able to continue to comply with such rules. If we fail to comply and cannot remedy our noncompliance during any applicable notice or grace periods, our common stock could be delisted from the NASDAQ Global Market. The delisting of our common stock would likely have a material adverse effect on the trading price, volume and marketability of our common stock.
Upon a delisting from the NASDAQ Global Market, our common stock would become subject to the penny stock rules of the SEC, in which event it is possible that the price of our common stock would further decline and likely that our stockholders would find it more difficult to sell their shares.
The following table sets forth information regarding the principal facilities we own or lease, the location and approximate size of each such facility or the size of the space leased at such property, and their designated use. We believe that these facilities are in good condition, enable us to serve our customers efficiently and are sufficient to meet our business needs for the foreseeable future.
* As of December 31, 2006, we had subleased a portion of this property to unrelated third parties, resulting in $0.4 million in future sublease payments to us during 2007.
We are not currently a party to any legal proceedings that would have a material adverse effect on our financial condition or results of operations.
The following table sets forth, as of March 1, 2007, information regarding the names and ages of all our executive officers and their respective positions and offices with us.
Mark D. Gessler has served as Chief Executive Officer since June 2000 and as President since prior to March 2000. Since March 2000, Mr. Gessler has been a member of our Board of Directors and from April 2001 to November 2004, he served as Chairman of the Board of Directors. Mr. Gessler holds an M.B.A. from the University of Tennessee.
Philip L. Rohrer, Jr. has served as Chief Financial Officer since prior to March 2000. Mr. Rohrer holds a B.A. in biology from Hood College and an M.S.M. from Frostburg State University.
F. Dudley Staples, Jr. has served as our Senior Vice President, Secretary and General Counsel since May 2002. From prior to March 2000 to May 2001, Mr. Staples served as General Counsel of Online Office Supplies Company, an online seller of office supplies and subsidiary of eCommerce Industries, Inc., and then as Associate General Counsel of eCommerce Industries, Inc. Mr. Staples holds a J.D. degree from the University of Virginia School of Law.
Louis A. Tartaglia, Ph.D. was appointed Chief Scientific Officer in February 2007. Prior to that appointment, he served as Senior Vice President and General Manager, Drug Repositioning and Selection beginning in January 2005. Dr. Tartaglia joined Gene Logic in July 2004 following Gene Logic's acquisition of certain technologies from Millennium Pharmaceuticals, Inc. From 2002 to 2004, Dr. Tartaglia served as Vice President of New Ventures at Millennium Pharmaceuticals, Inc. From 1999 to 2002, he served as Vice President of Metabolic Diseases. Dr. Tartaglia holds a Ph.D. in Biochemistry from the University of California, Berkeley.
Larry Tiffany has served as Senior Vice President, General Manager, Genomics since June 2006. Prior to returning to Gene Logic, Mr. Tiffany was President and Chief Business Officer of Genetraks, an Australian-based veterinary molecular diagnostics firm, from 2004-2006. Prior to joining Genetraks, Mr. Tiffany was VP, Worldwide Business Development for Gene Logic. Mr. Tiffany holds a J.D. degree from Franklin Pierce Law Center; a M.S. in Biotechnology from The Johns Hopkins University; and a B.S. in Chemistry from Nazareth College.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
Our Common Stock is traded on the NASDAQ Stock Market under the symbol GLGC. The following table sets forth information regarding the high and low closing prices for our Common Stock, for the periods indicated.
On March 1, 2007, the last reported sale price of our Common Stock on the NASDAQ Stock Market was $1.74. As of March 1, 2007, there were approximately 326 registered holders of record of our Common Stock, including one company, Cede & Co., which is the Registered Nominee for the Depository Trust Company, acting as holder of record for beneficial holders whose stock is held in street name.
Since we became a public company, we have not paid dividends on our Common Stock. Currently, we intend to retain future earnings, if any, to finance the growth and development of our business and do not anticipate paying cash dividends for the foreseeable future.
The selected consolidated financial data set forth below with respect to our consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004 and with respect to the consolidated balance sheets as of December 31, 2006 and 2005 have been derived from audited consolidated financial statements included as part of this Form 10-K. The statements of operations data for the years ended December 31, 2003 and 2002 and the balance sheet data as of December 31, 2004, 2003 and 2002 are derived from audited financial statements not included in this Form 10-K. The following selected consolidated financial data includes, for 2006, through 2003 only, the results for our Preclinical Division (resulting from the April 1, 2003 acquisition of TherImmune Research Corporation, which was subsequently sold December 15, 2006) and for 2006, 2005 and 2004 only, the results for our Drug Repositioning Division (resulting from the July 2004 acquisition of technologies from Millennium Pharmaceuticals, Inc.) and should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Form 10-K.
For 2006, 2005 and 2004, respectively, $3.7 million, $4.2 million, and $2.2 million in costs previously allocated to the Preclinical Division have been re-allocated to the Genomics and Drug Repositioning Divisions. These amounts represent costs that the Company has now determined will not be eliminated as a result of the sale of its Preclinical Division.
(1) Includes $10.9 million loss on disposal for the Preclinical Division.
(2) Includes $32.8 million impairment charge associated with the impairment of goodwill for the Preclinical Division.
We currently conduct our operations through two business segments:
In 2004, Gene Logic created a pharmaceutical development division (known as our Drug Repositioning Division) within the Company to identify and develop new or expanded uses for small molecule therapeutics. Based on advances in our pharmaceutical development division and changes in our Genomics business, and after concluding a comprehensive review of our strategy, we have decided to focus our resources on becoming a pharmaceutical development company. We are now building a therapeutic pipeline by applying our proprietary drug indication discovery platform to find new and expanded uses for drug candidates supplied by major pharmaceutical companies with whom we have drug development partnerships. We believe this strategy is the best way to create value for shareholders.
In 2005 and 2006, we entered into drug development partnerships with Pfizer, Inc., F. Hoffmann-La Roche Ltd, Eli Lilly and Company and NV Organon. In 2006, we began evaluating more than 40 drug candidates for our drug development partners. We have been able to develop alternative indication hypotheses for 25%-33% of these candidates for which evaluation is complete. Some of the candidates for which we have found new indications have or will progress to in vivo efficacy models to evaluate and support their suitability for re-entering clinical trials for the proposed new indications. We expect that some portion of the drug candidates will have successful outcomes in the in vivo tests and re-enter clinical trials, but we do not yet have sufficient data to estimate the rate of clinical trial re-entry. We do not expect any of these drug candidates to re-enter clinical trials until after 2007.
Early in 2006, it began to become apparent that our customers had begun to shift their emphasis away from research on early stage drug discovery where many of our Genomics services have been targeted, to later stage development and validation efforts. In response to the declining sales and financial performance that resulted from this change in emphasis, we restructured the Division and also began to explore new avenues of value for our Genomics Division, including capitalizing on our commercially demonstrated expertise in biomarker development as a potential platform for molecular diagnostics development. We engaged outside financial advisors to consider strategic alternatives for our Genomics business. We continue to serve new and existing Genomics customers while we explore these alternatives.
Also in 2006, we announced the closing of the sale of Gene Logic Laboratories, Inc. to Bridge Pharmaceuticals, Inc. (“Bridge”) for a sales price of $15.0 million, including $13.5 million paid at closing less transaction costs of $1.4 million and $1.5 million held in escrow for 12 months to guarantee certain obligations under the agreement. The purchase price remains subject to adjustment for certain changes in working capital and the assumption of certain liabilities associated with the business. In addition, we provide certain transition services under and an agreement with Bridge and our guarantees of two leases continue in effect pending their assignment to and assumption by Bridge. If the guarantees are not assumed by Bridge, then Bridge will indemnify us with respect to such guarantees. The Preclinical Division provided contract research services enabling customers to assess the safety and pharmacologic effects of compounds. We decided to sell the Preclinical Division because the business provided insufficient strategic or synergistic advantage to our pharmaceutical development, genomics or molecular diagnostics efforts.
Currently, most of our revenue comes from our Genomics Division. Historically, we have derived a majority of our Genomics Division revenue from licenses to our databases in the form of multi-year subscriptions and annual subscriptions to our smaller databases or a subset of our larger databases. We have also granted perpetual licenses to our data and/or software tools. We also generate revenue from providing other services, including various toxicogenomics reports, microarray data generation and analysis and other professional services. Fees are payable ratably over the life of the agreement for multi-year agreements, ratably or up-front for shorter-term agreements and, in the case of perpetual licenses, upon delivery of the data or software. Generally, our Genomics Division contracts may be terminated in the event of breach by either party not cured within any applicable cure period. In the past, we have invested in new database content, upgraded our databases and developed new versions of our software tools. Future investments will be limited as we continue the transformation of Gene Logic into a biopharmaceutical company.
We have developed partnerships with four pharmaceutical partners in 2005 and 2006: Pfizer, Inc., F. Hoffmann-La Roche Ltd, Eli Lilly and Company, and NV Organon. Our agreement with NV Organon involves co-ownership and co-development of repositioned drug candidates, and it therefore differs substantially from our other agreements. Our other drug repositioning and development agreements vary somewhat as to specific terms (see “Contractual Arrangements” earlier), but generally conform to the following:
In most cases, if our partner decides not to take the drug candidate back into development, we have development rights that would entitle our partner to receive milestone payments and royalties on sales. We may choose to license such candidates to a third party for development, or we may invest in further development to increase a particular candidate’s value prior to outlicensing. We have acquired certain rights from Millennium Pharmaceuticals to a drug candidate for which we have identified potential new indications.
We have incurred net losses in each year since our inception, including losses of $54.7 million in 2006, $48.3 million in 2005 and $28.5 million in 2004. At December 31, 2006, we had an accumulated deficit of $315.7 million. Our losses have resulted principally from costs incurred in the development, marketing and sale of services from our Genomics and Preclinical Divisions, development of the Drug Repositioning Division, the impairment of our Preclinical Division goodwill and acquisitions of research and development. These costs have exceeded our revenue and we expect to incur additional losses in the future.
Revenue. We primarily derive our revenue from our Genomics Division services. To date, we have recorded no meaningful revenue from our Drug Repositioning Division. Revenue from continuing operations decreased $32.8 million, or 57%, to $24.3 million in 2006 from $57.2 million in 2005. During 2006, three customers each accounted for greater than 10% of our total revenue. During 2005, two customers accounted for greater than 10% of our total revenue. The 2006 decrease in revenue resulted from declining subscription revenue, the absence of anticipated sales of perpetual licenses to database products and slower than anticipated sales growth for microarray data generation and analysis services. These changes were caused primarily by our customers’ having shifted their emphasis from research on early stage drug development, for which many of our Genomics Division services are targeted, into later-stage development and validation efforts. The 2006 results reflect the absence of $28.6 million in subscription fees from expired agreements, $2.7 million less for perpetual license fees and reduced revenue of $2.4 million from certain agreements with existing customers renegotiated at reduced service levels, partially offset by higher revenue of $2.8 million from increased microarray data generation and analysis services in 2006.
In 2006, long-term subscription agreements with five customers were to expire by their terms and two agreements allowed for early termination at the customer’s election. These agreements accounted for 38% of our Genomics services revenue in 2006, of which 16% consisted of revenue from the sale of perpetual licenses to data and software. As to the two agreements that were subject to early termination at the customer’s election, one customer terminated its agreement early and one customer elected to continue its agreement. As to the remaining five agreements, four agreements have expired by their terms and one was terminated by mutual agreement. Three of these customers purchased perpetual licenses to data and software in connection with their respective terminations.
Our remaining long-term subscriptions are due to expire by their terms in 2008. For 2007, we expect to continue to derive more revenue from our other services and reduce our revenue from large, multi-year subscription agreements.
Database Production Expense. Database production expenses, which consist primarily of costs to provide microarray data generation and analysis services and costs related to the acquisition and processing of tissues and overhead expenses needed to generate the content for the BioExpress and ToxExpress System databases, decreased to $27.4 million for 2006 from $31.7 million for 2005. The decrease consisted primarily of a $4.2 million reduction in database production expenses, including lower costs for agreements with third parties, partially offset by $1.0 million increase in inventory reserves in 2006. For 2007, we expect database production expenses to decrease due to the restructuring of the Genomics Division and increased customer demand for microarray data generation and analysis services.
Research and Development Expense. Research and development expenses, which consist primarily of costs associated with the evaluation of customer-supplied drug candidates and ongoing development of our drug indication discovery platform, increased to $9.9 million for 2006 from $6.8 million for 2005. The increase was primarily the result of large numbers of evaluations of drug candidates begun under the terms of our drug discovery partnerships. For 2007, we expect research and development expenses to increase modestly, as we continue to evaluate drug candidates supplied by our drug discovery partners and further develop our indication discovery platform. In addition, we may incur additional expenses if we decide to pursue further development of a drug candidate for which we acquired certain rights from Millennium in 2006.
Selling, General and Administrative Expense. Selling, general and administrative expenses from continuing operations, which consist primarily of sales, marketing, accounting, legal, human resources and other general corporate expenses, decreased to $22.4 million for 2006 from $26.8 million for 2005. The decrease is largely due a reduction of $2.0 million in costs under the terms of our 2006 annual employee incentive compensation plan and lower payroll expense for Genomics Division and Corporate staff. For 2007, we expect selling, general and administrative expenses to decrease, primarily due to the restructuring of the Genomics Division.
Genomics Division Restructuring Expense. During 2006, we initiated a restructuring of our Genomics Division, which is expected to be substantially completed by December 31, 2007. This restructuring included the termination of 70 employees, which resulted in severance costs of $1.5 million; the acceleration of future costs of $2.4 million for certain laboratory and office facilities that were no longer needed for continuing operations and were either abandoned or for which we have entered into sublease arrangements; and the impairment of certain intangible assets of $1.3 million, primarily patent and license costs, which we determined would no longer be utilized by our Genomics Division. Once fully implemented, we estimate that the staff reductions will reduce our annual salary and fringe benefits costs by approximately $8.0 million and we expect to realize additional savings in certain non-employee costs in connection with this restructuring.
Net Interest Income. Net interest income increased to $2.7 million for 2006 from $2.6 million for 2005, due to increases in our rates of return on investments, largely offset by a decline in the balance of our cash and cash equivalents and marketable securities available-for-sale.
Other (Income) Expense. Other (income) expense was an expense of $0.1 million for 2006 compared to income of $0.8 million for 2005, due to foreign currency transaction losses and gains in each period, respectively, relating to our subscription agreements with our Japanese customers. Beginning in 2005, as a result of changing our distribution arrangements in Japan, our agreements with our Japanese customers are now denominated in Japanese Yen.
Write-down of Other-than-Temporary Decline in the Value of Marketable Securities Available-for-Sale. In 2005, we recorded a $0.7 million write-down of our investment in Avalon Pharmaceuticals, Inc., due to an other-than-temporary decline in its estimated market value.
Write-down of Equity Investment. In connection with our investment in Xceed Molecular (“Xceed”, formerly MetriGenix Corporation) in 2003, we had entered into a subscription agreement granting Xceed a license to use our BioExpress System and had been issued a warrant to enable us to maintain our 15% equity ownership in Xceed, which would terminate upon termination of the subscription agreement. In 2006, we terminated the subscription agreement by mutual agreement and the warrant was therefore terminated. As a result, we recorded a $0.3 million write-down of the fair value of this warrant during 2006. At December 31, 2006, the remaining book value of our investment in Xceed was $3.0 million, which we believe approximates fair value.
Revenue. Revenue from continuing operations increased $5.0 million, or 10%, to $57.2 million in 2005 from $52.2 million in 2004. During 2005, two customers each accounted for greater than 10% of our total revenue. During 2004, one customer accounted for greater than 10% of our total revenue. The increase in 2005 reflected $11.7 million in additional revenue from sales to several existing customers of perpetual licenses for certain data and software, partially offset by $4.2 million less revenue from certain agreement extensions at reduced service levels and the absence of $3.9 million in subscription fees from agreements that expired.
Database Production Expense. Database production expenses, which consisted primarily of costs related to the acquisition and processing of tissues and overhead expenses needed to generate additional content for the BioExpress and ToxExpress System databases, decreased to $31.7 million for 2005 from $41.9 million for 2004. The decrease consisted primarily of a $7.6 million reduction in database production expenses, including lower costs for acquiring tissues and certain agreements with third parties, and a decrease of $3.1 million in depreciation and amortization expense.
Research and Development Expense. Research and development expenses, associated primarily with our Drug Repositioning Division, increased to $6.8 million for 2005 from $2.4 million for 2004. The increase was primarily a result of further development of the biological screening technologies acquired from Millennium in 2004.
Selling, General and Administrative Expense. Selling, general and administrative expenses, which consist primarily of sales, marketing, accounting, legal, human resources and other general corporate expenses, increased to $26.8 million for 2005 from $19.2 million for 2004. The increase is largely due to an increase of $4.4 million in our investment in our Drug Repositioning Division and increased costs under our 2005 annual employee incentive compensation plan.
Purchased Research and Development. During 2004, we incurred a one-time expense of $8.8 million for the write-off of purchased in-process research and development associated with the acquisition of biological screening technologies acquired from Millennium.
Net Interest Income. Net interest income increased to $2.6 million for 2005 from $1.4 million for 2004, due to increases in our rates of return on investments, partially offset by a decline in the balance of our cash and cash equivalents and marketable securities available-for-sale.
Other (Income) Expense. Other (income) expense increased to $0.8 million for 2005 from zero for 2004, due to foreign currency transaction gains relating to our Japanese customers. Beginning in 2005, as a result of changing our Japanese distribution arrangements, our agreements with our Japanese customers are denominated in Japanese Yen.
Write-down of Other-than-Temporary Decline in the Value of Marketable Securities Available-for-Sale. In 2005, we recorded a $0.7 million write-down of our investment in Avalon Pharmaceuticals, Inc., due to an other-than-temporary decline in its estimated market value.
LIQUIDITY AND CAPITAL RESOURCES
From inception through December 31, 2006, we have financed our operations and acquisitions through the issuance and sale of equity securities and payments from customers. As of December 31, 2006, we had approximately $50.1 million in cash, cash equivalents and marketable securities available-for-sale, compared to $82.1 million as of December 31, 2005.
Net cash from operating activities from continuing operations decreased to a negative $34.0 million for 2006 from a positive $6.1 million for 2005, primarily due to our increased net loss from continuing operations for 2006, the timing of customer payments (including prepayments) for our services in 2005 and payments in 2006 to Millennium and under our compensation and retention plans. We presently anticipate that our use of cash for 2007 will be lower due to an anticipated lower net loss from continuing operations.
During 2006 and 2005, our investing activities consisted primarily of purchases, sales and maturities of available-for-sale securities, capital expenditures and software development and database upgrade costs. Capital expenditures for 2006 and 2005 were $2.0 million and $9.9 million, respectively. The decrease in capital expenditures was primarily due to the completion in 2005 of a significant facility renovation. For 2007, we do not expect the level of capital expenditures to be significant.
We have capitalized software development costs of $1.0 million and $2.1 million for 2006 and 2005, respectively. These costs related to efforts to enhance the software platform of our BioExpress and ToxExpress System databases. Also, we have incurred database upgrade costs of $2.6 million and $4.2 million for 2006 and 2005, respectively, enhancing the content of our databases using new versions of microarrays from Affymetrix. Future investments in upgrades and new versions of our software tools are being evaluated as part of our overall strategy for the Genomics Division.
In 2006, we announced the closing of the sale of our Preclinical Division to Bridge for a sales price of $15.0 million, including $13.5 million paid at closing less transaction costs of $1.4 million and $1.5 million held in escrow for 12 months to guarantee certain obligations under the agreement.
Our financing activities, other than the repayment of an equipment loan, have primarily consisted of the exercise of stock options.
In July 2004, we purchased and licensed certain biological screening technologies utilized by our Drug Repositioning Division and hired a research team from Millennium. During 2006, we paid Millennium $3.5 million in cash representing the final installment of the purchase price. In connection with the purchase, we also contractually agreed to, and subsequently met, a commitment to spend an aggregate of $14.5 million to further develop and commercialize these technologies.
To generate our gene expression data, we use Affymetrix microarrays, instrumentation and software. Under the terms of our current supply and license agreements with Affymetrix, we do not have a purchase commitment. In 2006, under the prior agreement, we agreed to purchase a minimum of $7.1 million in products and services from Affymetrix in 2006. As of December 31, 2006, we had met this commitment.
Specific future financial commitments from continuing operations as of December 31, 2006 are set forth in the following table:
We believe that existing cash, cash equivalents and marketable securities available-for-sale and anticipated payments from customers will be sufficient to support our operations for the foreseeable future. These estimates are forward-looking statements that involve risks and uncertainties. Our actual future capital requirements and the adequacy of our available funds will depend on many factors, including those discussed under “Risks Related to Our Business and Industry” elsewhere in this Report.
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. The following discussion highlights what we believe to be the critical accounting policies and judgments made in the preparation of these consolidated financial statements.
Revenue is recognized in accordance with the SEC’s Staff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB 104”). SAB 104 requires that four basic criteria be met before revenue can be recognized: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred or services rendered; 3) the fee is fixed and determinable; and 4) collectability is reasonably assured. As to 1), our business practices require that our services be performed pursuant to contracts with our customers. As to 2), we recognize revenue when services are rendered to our customers. Determination of 3) and 4) are based on management’s judgments regarding the fixed nature of our arrangements taking into account termination provisions and the collectability of fees under our arrangements. Should changes in conditions cause management to determine these criteria are not met for certain future arrangements, revenue recognized for any reporting period would be adjusted and could be adversely affected.
In accordance with Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”, revenue recognized for any multiple-element contract is allocated to each element of the arrangement based on the relative fair value of the element. The determination of fair value of each element is based on our analysis of objective evidence from comparable internal or third-parties’ sales of the individual element. If we are unable to determine evidence of fair value for an undelivered element of the arrangement, revenue for the arrangement is deferred and recognized using the revenue recognition method appropriate to the predominant undelivered element.
Genomics Services Revenue. Through 2006, the majority of Genomics services revenue consists of fees earned under subscription agreements for all or parts of our gene expression databases, the BioExpress System and ToxExpress System, which are typically for a specific multi-year term for the larger databases and annual terms for smaller parts of the databases. We have also granted to some customers perpetual licenses to certain data from our BioExpress and ToxExpress System databases and software tools. In addition, we have generated a smaller, but growing percentage of revenue from providing other services, including various toxicogenomics reports, microarray data generation and analysis and other professional services. Revenue from subscription agreements is recognized ratably over the period during which the customer has access to the database. Certain subscription agreements have included a right of early termination (which, in some instances, is subject to conditions) by the customer, without penalty, on a specified date prior to the normal expiration of the term. If any agreement has a right of early termination, revenue is recognized ratably over the subscription term up to the possible date of early termination, based on subscription fees earned under the agreement through the possible date of early termination. If such early termination does not occur, the balance of the subscription fees earned under the agreement is recognized as revenue ratably over the remaining term of the agreement. Revenue from perpetual licenses to data and software for which the Company is not obligated to provide continuing support or services is recognized when the data and/or software has been delivered. Revenue from perpetual licenses for which the Company is obligated to provide continuing support or services is recognized during the period such support or services are provided. Revenue from other services is recognized when the services are performed. Our agreements generally provide for termination in the event of a breach of the agreement by either party or a bankruptcy or insolvency of either party.
Periodically, we enter into contractual arrangements with multiple deliverables. If we are unable to determine objectively and reliably the fair value of individual undelivered elements, we recognize all revenue using the revenue recognition method appropriate to the predominant undelivered element. We also defer the direct and incremental expenses associated with the delivery of services for which revenue has been deferred and recognize these expenses as we recognize the related revenue. The timing of revenue recognition associated with agreements we enter into in future periods may also be dependent on our ability to objectively and reliably determine the fair value of deliverables included in those agreements.
In 2003, we recorded goodwill of $43.0 million as a result of the acquisition of TherImmune Research Corporation (later renamed Gene Logic Laboratories Inc., our former Preclinical Division). In addition, we’ve previously recorded value for goodwill and other intangible assets, including licenses to technologies or data, patent costs and software development and database upgrade costs. The determination of whether or not these other intangible assets are impaired involves significant judgment, including the following: (i) our licenses and internally developed intellectual property may not provide valid and economical competitive advantage; and (ii) our services may become obsolete before we recover the costs incurred in connection with their development.
Under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”, we are required to perform an annual impairment test of our goodwill and periodic reviews of our other intangible assets. In addition, we are required to test for impairment at any point we have an indication that impairment may exist. We have elected to perform our annual impairment test of goodwill as of October 1. The goodwill impairment test that we have historically selected consisted of a ten-year discounted cash flow analysis, including the determination of a terminal value, and required management to make various judgments and assumptions, including revenue growth rates and discount rates, which management believed to be reasonable.
In conjunction with our review of assets held for sale of the Preclinical Division, we determined that the remaining value of the goodwill that resulted from the acquisition of TherImmune (later renamed Gene Logic Laboratories Inc., our former Preclinical Division) was likely impaired, due to our assessment of the possible indications of fair value resulting from our decision to consider the sale of the division. As a result, we recorded a non-cash expense of $10.2 million which was included in the $11.0 million impairment charge in the third quarter of 2006 representing the implied impairment of goodwill of our Preclinical Division. During the third quarter of 2005, we recorded a non-cash expense of $32.8 million representing the implied impairment of goodwill of our Preclinical Division. These non-cash expenses are included in the loss from discontinued operations of our Preclinical Division for the respective periods.
As part of our annual testing of goodwill, we determined that no impairment existed in the carrying value of goodwill of our Genomics Division. However, due to the restructuring of our Genomics Division, we recorded impairment charges of $1.3 million in the third quarter of 2006 for certain intangible assets which we determined would no longer be utilized by our Genomics Division.
Our assessment of the fair value of our divisions is dependent on subjective estimates we make of inherently uncertain future net cash flows including estimates of terminal values. Accordingly, our estimates for future periods of net cash flows may change as market conditions and circumstances dictate. Future impairment tests of goodwill for our Genomics Division and other intangibles may result in additional impairment charges based on these changing estimates.
ACCOUNTS RECEIVABLE AND UNBILLED SERVICES
Our ability to collect outstanding receivables and unbilled services from our customers is critical to our operating performance and cash flows. Typically, arrangements with our customers require that the payments for our services be made in advance, based upon the achievement of milestones or in accordance with predetermined payment schedules. We have an allowance for doubtful accounts based on our estimate of accounts receivable that are at risk of collection. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, an increase in the allowance for doubtful accounts may be required.
We maintain an inventory of tissue samples collected from various commercial and academic sites that are used to expand the content of our databases. We assess the quality and supply of samples in excess of our current requirements in determining appropriate reserves. Our methods for calculating these reserves are based both on historical performance and management estimates. Inventory reserves are reviewed for adjustment on an ongoing basis. Changes in tissue quality and/or our requirements for their use could potentially cause adjustments to these reserves in future periods.
We also maintain an inventory of microarrays and reagents used to generate genomic data for our databases and for services in our Genomics Division. This inventory is valued at the lower of cost or market. Certain items in inventory may be considered impaired, obsolete, or excessive and as such, we may establish an allowance to reduce the carrying value of these items to their net realizable value. Based on certain estimates, assumptions and judgments made from information available at the time, we determine the appropriate amount of any such inventory allowance. If these estimates or assumptions or the market for the use of our microarrays and reagents change, we may be required to record additional reserves.
Following the write-down of $0.3 million in 2006, we hold an equity investment in one company (Xceed Molecular, formerly MetriGenix) with a remaining book value of $3.0 million as of December 31, 2006. We record an investment impairment charge when it is believed that an investment has experienced a decline in value that is other-than-temporary. Future adverse changes in market conditions or poor operating results of the underlying investee could result in our inability to recover the carrying value of this investment that may not be reflected in such an investment’s current carrying value, thereby possibly requiring an impairment charge in the future.
In the first quarter of 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires us to expense the fair value of stock-based compensation awards of our various stock-based compensation programs over the requisite service period of the award. We estimate the fair value of our stock-based compensation using fair value pricing models which require the use of significant assumptions for expected volatility of our common stock, life of stock options and risk-free interest rate. Future adverse changes in such assumptions could result in us recording increased stock-based compensation expenses for stock-based compensation awards granted/issued in the future.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and states that a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. This Statement applies under other accounting pronouncements that require or permit fair value measurements, for which the FASB previously concluded in such accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, which we intend to adopt on January 1, 2008. We are currently evaluating the impact, if any, that SFAS 157 will have on our financial position, results of operations and cash flows, but do not believe the effect will be material.
In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48") which clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not expect the adoption of this Interpretation to have a material impact on our financial statements.
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method, and therefore have not restated results for prior periods. Under this method, we recognize compensation expense for all share-based payments granted after January 1, 2006 and for those that were granted prior to, but have not yet vested as of, January 1, 2006, in accordance with SFAS 123R. For 2006, stock-based compensation awards consisted of options awarded under the 1997 Equity Incentive Plan and the 1997 Non-Employee Directors’ Stock Option Plan. Under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation net of an estimated forfeiture rate and recognize the compensation cost for those shares expected to vest on a straight-line basis over the requisite service period of the award. Prior to SFAS 123R adoption, we accounted for share-based payments under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and accordingly, were required to recognize compensation expense only to the extent that the fair value of the underlying stock on the date of grant exceeded the exercise or acquisition price of the stock or stock-based award. Since stock options granted by us in the last several years have been granted with an exercise price equal to the fair value on the grant date, we did not recognize any expense for such options prior to our adoption of SFAS 123R.
Our net loss from continuing operations and total net loss for 2006 were impacted by the recognition of $0.6 million and $0.8 million, respectively, in non-cash expense related to the fair value of our stock-based compensation awards. The impact of stock compensation expense in future periods will be dependent on the number and type of share-based payments issued to employees and non-employee directors.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We have exposure to financial market risks, including changes in interest rates. At December 31, 2006, we had cash and cash equivalents of approximately $25.7 million and marketable securities available-for-sale of an additional $24.4 million. We invest our excess cash primarily in money market funds, obligations of the U.S. Government and its agencies and marketable debt securities of companies with strong credit ratings. These instruments have maturities of twenty-four months or less when purchased. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that, while the instruments we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments. Based on our cash and cash equivalents and marketable securities available-for-sale balances at December 31, 2006, a hypothetical 100 basis point adverse movement in interest rates would have resulted in an increase in the net loss of approximately $0.5 million for the year ended December 31, 2006. Actual changes in rates may differ from the hypothetical assumptions used in computing this exposure.
Since the beginning of 2005 and as a result of changing our distribution arrangements in Japan, we have been subject to risk from changes in foreign exchange rates relating to revenue with our Japanese customers, as such agreements are now denominated in Japanese Yen. Such changes could result in foreign currency exchange gains or losses. As a policy, we convert our customer payments made in Japanese Yen to United States dollars upon receipt of such payments. Revenue derived from the Pacific Rim as a percentage of total revenue was 39% for the year ended December 31, 2006 and was primarily derived from our customers in Japan. Exchange rate fluctuations between the United States dollar and Japan could result in positive or negative fluctuations in the amounts relating to revenue reported in our consolidated financial statements. A hypothetical 10% adverse change in average foreign currency movements would have resulted in an increase in the net loss of approximately $0.7 million for the year ended December 31, 2006. There can be no assurance that losses related to this currency risk will not occur.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our Consolidated Financial Statements and notes thereto, together with the Reports of Independent Registered Public Accounting Firm, appear on pages F-1 through F-22 of this Annual Report on Form 10-K and are incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
ITEM 9A. CONTROLS AND PROCEDURES
Attached as exhibits to this Form 10-K are certifications of our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the Exchange Act). This “Controls and Procedures” section includes information concerning the controls and controls evaluation referred to in the certifications. Part II, Item 8 of this Form 10-K sets forth the report of Ernst & Young LLP, our independent registered public accounting firm, regarding its audit of our internal control over financial reporting and of management’s assessment of internal control over financial reporting set forth below in this section. This section should be read in conjunction with the certifications and the Ernst & Young LLP report for a more complete understanding of the topics presented.
As of December 31, 2006, under the supervision and with the participation of our management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), an evaluation was performed of the effectiveness of the design and operation of our “disclosure controls and procedures” (“Disclosure Controls”). These are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed under the Exchange Act, such as this Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the United States Securities and Exchange Commission (“SEC”). Disclosure Controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the CEO and CFO as appropriate, to allow timely decisions regarding required disclosure. Based on that evaluation, our CEO and CFO have concluded that, as of December 31, 2006, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC, and that material information relating to us is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared.
Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent or detect all errors and all instances of fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based, in part, on certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of the effectiveness of controls to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate “internal control over financial reporting” to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2006 based on the framework in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2006 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles.
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm. Ernst & Young LLP has issued an attestation report concurring with management’s assessment, which is included in Part II, Item 8 of this Form 10-K.
There were no changes in our internal controls over financial reporting during the fourth quarter of 2006 that materially affected or are reasonably likely to materially affect our internal controls over financial reporting.
ITEM 9B. OTHER INFORMATION
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
IDENTIFICATION OF DIRECTORS
The information required by this item is incorporated by reference to the information set forth in the section entitled “Election of Directors,” contained in the Company’s definitive Proxy Statement for the 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days following the Company’s fiscal year ended December 31, 2006 (the “Proxy Statement”).
The information required by this item is incorporated by reference to the information set forth in the section entitled “Executive Officers” in Part I, following Item 4 of this Annual Report on Form 10-K.
The information required by this item is incorporated by reference to the information set forth in the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance,” contained in the Proxy Statement.
The information required by this item is incorporated by reference to the information set forth in the section entitled “Corporate Governance,” contained in the Proxy Statement.
The information required by this item is incorporated by reference to the information set forth in the section entitled “Executive Compensation,” contained in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED MATTERS
The information required by this item is incorporated by reference to the information set forth in the section entitled “Security Ownership of Certain Beneficial Owners and Management,” contained in the Proxy Statement.
The information required by this item is incorporated by reference to the information set forth in the section entitled “Certain Transactions,” contained in the Proxy Statement.
The information required by this item is incorporated by reference to the information set forth in the section entitled “Principal Accountant Fees and Services,” contained in the Proxy Statement.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES
(a) 1. Financial Statements
(a) 2. Financial Statement Schedules
All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instruction or are inapplicable and therefore have been omitted.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 16th day of March, 2007.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Gene Logic Inc.
Index to Consolidated Financial Statements
Internal Control Over Financial Reporting
The Board of Directors and Stockholders of Gene Logic Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Controls Over Financial Reporting listed as Item 9A, that Gene Logic Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Gene Logic Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Gene Logic Inc. maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Gene Logic Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Gene Logic Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006, and our report dated March 14, 2007 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
March 14, 2007
Consolidated Financial Statements
The Board of Directors and Stockholders Gene Logic Inc.
We have audited the accompanying consolidated balance sheets of Gene Logic Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Gene Logic Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, in 2006, the Company changed its method of accounting for stock-based compensation upon the adoption of Statement of Financial Accounting Standard No. 123(R), “Shared-Based Payments”.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Gene Logic Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2007 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
March 14, 2007
Consolidated Balance Sheets
as of December 31, 2006 and 2005
(in thousands, except share data)
Consolidated Statements of Operations
For the Years Ended December 31, 2006, 2005 and 2004
(in thousands, except per share data)
Consolidated Statements of Stockholders’ Equity
For the Years Ended December 31, 2004, 2005 and 2006
(in thousands, except number of shares)