ITEM 1. Business
The Company
Epoch Biosciences, Inc. is a biotechnology company developing technologies and products to help scientists around the world perform genetic research to improve our lives and our environment. Genetic analysis has become a pervasive activity in academic, biopharmaceutical, clinical, agricultural, veterinary and forensic laboratories. Our technologies facilitate rapid, accurate and cost-effective genetic analysis at the scale necessary to generate the massive amounts of genetic information being studied today.
As the human genome and other animal and plant genomes are sequenced, the task of understanding the structure and function of genes lies before us (genomics). Researchers want to know when and why a gene switches on and begins producing its protein (gene expression) and what the gene’s protein does in the body (proteomics). Finally, researchers want to know what people’s genetic differences mean for their health and susceptibility to disease. For example, single nucleotide polymorphisms, or SNPs, are tiny differences in our DNA that make humans different from one another. SNPs have been linked to susceptibility to diseases, and to people’s response to medications.
Because of the implications of understanding gene function on human health and disease, companies have moved quickly to design and manufacture automated genetic analysis systems. We develop patented technologies that improve the output of these systems and that are compatible with many of the genetic analysis systems currently in use or in development. Just as microprocessors are found in essentially all electronic appliances, our chemistries and technologies have the potential to be incorporated in nearly all genetic analysis systems.
Our technologies are useful in genetic research, diagnostics, drug development, infectious disease detection, prenatal testing, and population screening to assess our risk of disease or to predict our response to drugs. Epoch’s products also have application in forensics, food testing, and environmental testing, including bio-warfare and bioterrorism.
We earn revenues through a variety of sources. We sell our products to end-users, both through our direct sales force and through distributors that provide worldwide reach. We license our technology for incorporation into other companies’ products and earn license fees and royalties from those companies and generate product revenue from sales of our chemistries to them. We also earn revenues through contract research activities, whereby third party companies pay for specific research and development activities carried out by our scientists.
The following table summarizes our revenues by major category, for the last three years ($ in thousands):
We incorporated in Delaware on August 14, 1985, under the name MicroProbe Corporation. We changed our name to Epoch Pharmaceuticals, Inc. in December 1995, and to Epoch Biosciences, Inc. in August, 2000. Our principal office is located at 21720 23rd Drive SE, #150, Bothell, Washington, and our telephone number is (425) 482-5555. Our website address is www.epochbio.com.
Background
Nucleic acids are found in all living organisms and are the sole carriers of the genetic code that specifies an organism’s makeup. There are two types of closely related nucleic acids: deoxyribonucleic acid, or DNA, and ribonucleic acid, or RNA. DNA carries the permanent genetic information for construction of all proteins in higher living organisms, while RNA carries a temporary copy of this information to direct protein synthesis. Proteins perform most of the normal physiological functions of living organisms, and aberrant production or activity of proteins may cause numerous diseases.
Figure 1. Segment of Double-Stranded DNA Showing the Base Pair Relationship
DNA is comprised of two linear strands that are formed in a double helix. Each strand is a sequential array of four nucleotide bases: adenine (A), guanine (G), thymine (T) and cytosine (C), which are linked together in DNA by a sugar and phosphate backbone. Every gene contains a unique sequence of these bases and it is these unique sequences that constitute the genetic code which guides all cellular processes. The two chains, or strands, normally comprising DNA are held together by chemical attractions between opposing paired bases according to the following rules: A always pairs with T, G always pairs with C. Figure 1 is a schematic diagram of double-stranded DNA showing this highly specific interaction between the bases in the two strands. This process of base pairing, called hybridization, can occur between DNA strands of any size, as long as the paired segments are matched correctly.
RNA occurs in several forms in cells, and each of these forms has a different function. Messenger RNA, or mRNA, is copied from the gene and carries the genetic code which is translated into the proteins synthesized by the cell. This process is called gene expression.
Synthetic DNA strands, or probes, can be designed to bind selectively to unique sequences of bases in a sample of DNA from an individual. If the probe binds to its target sequence a signal is generated. This method of genetic analysis is widely employed to measure the activity of genes, to identify infectious organisms, or to identify genetic differences between species or individuals. Our expertise in the chemistry, design and synthesis of synthetic DNA forms the basis of our research and development activities on compounds and techniques for genetic analysis.
Overview
Genetic analysis has become the most important laboratory technique in the life sciences. The massive effort to sequence the human genome is paralleled by projects to sequence the genomes of infectious organisms, research animals including fruit flies, worms and rats, and important food crops. It is estimated that over $3.5 billion was spent worldwide in 2001 on industrial and academic research to
understand human gene function and that the worldwide market for genomic analysis products, which consists of reagents, assays and other consumables, was $1 billion in 2001. This research effort is revolutionizing the pharmaceutical and diagnostic industries, as well as the fields of crop science, animal breeding and veterinary medicine. In the area of human health, genetic analysis promises to identify the mutations that cause hereditary diseases, to elucidate the genetic events that lead to cancer and determine the relative malignancy of tumors, to identify our individual risk for developing chronic illnesses like heart disease and arthritis, and to predict our response to medications.
The promise of genetic analysis and a rapid surge in research activity has created a demand for new technologies and systems to accelerate the pace and accuracy of genetic research. Techniques to study gene expression levels and detect differences in gene sequences are rapidly evolving. As the amount of data being generated grows, the demand for simple, accurate, high throughput formats is increasing. New technologies are generating great interest, such as TaqMan® MGB systems from Applied Biosystems, Primer Extension, a DNA analysis system developed by Orchid BioSciences, Sequenom and others, the Invader® operating system from Third Wave Technologies, microarray technologies being developed by Affymetrix and others, and microfluidic platforms under development at Caliper Technologies and others.
Today, genetic analysis is primarily a research activity carried out in thousands of academic, industrial, and government laboratories. Within a few years, we believe these analyses will be used not only in research, but also in doctors’ offices and clinics, on farms and ranches, at food-processing plants, in factories, at crime scenes, and on the battlefield. We believe that simple, inexpensive DNA tests have a future in almost every aspect of everyday life.
We have developed chemical compounds that broadly facilitate genetic analysis. Our chemistries include minor groove binders, modified bases, novel fluorescent molecules and non-fluorescent quenchers, and a unique chemistry to attach synthetic DNA strands to solid surfaces. When these chemical compounds are attached to or incorporated into DNA probes, they enhance methods to measure gene expression and to detect a difference of a single base in the DNA of different individuals, called a single nucleotide polymorphism, or SNP. Our compounds are compatible with multiple technologies, including polymerase chain reaction, or PCR, and alternative nucleic acid amplification technologies. Our technologies are used in multiple formats, including high throughput systems and microtiter plate formats, and they can be used in solution or on solid surfaces, including microarrays.
The commercialization of our technologies has led to development of our current proprietary products which include the MGB Eclipse™ Probe System.
We are collaborating with companies that are interested in improving the speed, accuracy, and simplicity of their tests and applications by using our proprietary chemistries. We have a strategic partnership with Applied Biosystems, where our technology is incorporated into all their TaqMan® real-time PCR systems. We have licensed our technology to Third Wave Technologies for use in their Invader® operating system. We are also entering into agreements with companies with worldwide reach to market our products. We’ve named Amersham Biosciences a marketing and sales partner for our MGB Eclipse Probe Systems, and have licensed our MGB Eclipse Probe System technology to QIAGEN for incorporation into its gene expression product line. We anticipate forming business relationships with other companies to distribute our products and/or incorporate our technologies in their genetic analysis products.
Genetic analysis
As of June 2000, the Human Genome Project and Celera announced that they had sequenced the entire human genome of over 3 billion base pairs. At the same time, Incyte Genomics and Human Genome Sciences had identified partial sequences for the majority of human genes.
Sequencing the human genome has been likened to the discovery of the elements and their arrangement in the periodic table: it only reveals the underlying structure and order of the system. With the human genome completely sequenced, we know approximately how many genes our chromosomes contain and where the genes are located on the chromosomes. However, that information generates many more questions than it answers. Searching for the answers to those questions will result in a rapid growth in the field of genetic analysis, with a parallel growth in technologies and products that facilitate that effort.
Among the most important issues that genetic research will address in the future are:
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How does our genetic diversity - the differences in the sequence of the four bases that make up our DNA - affect our response to drugs, and contribute to our susceptibility to chronic diseases, including cancer and cardiovascular disease?
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How do differences in the expression of genes in our various tissues affect development and contribute to health and illness?
SNP detection
The sequence of the four nucleotides (A,G,T,C) in our DNA determines our genetic makeup. Differences in this sequence, in large part, determine the uniqueness of each individual. Sites in the sequence which differ due to inheritance are called polymorphisms. One type of polymorphism is due to a change in a single base in the genetic DNA sequence. These single base polymorphisms, or SNPs, occur frequently enough along our DNA so that they can be used as markers on a “map” of the genome. Such a map can be used to localize traits such as hypertension, diabetes or sensitivity to therapeutic drugs by identifying SNPs that occur at a higher frequency in individuals with the trait than those without the trait. Knowing where the SNPs associated with the trait occur, one can look for nearby genes responsible for the trait, thus leading to a genetic understanding of the trait and directing efforts for treatment. Some SNPs have been shown to cause disease, or to be associated with risk for disease or adverse drug response. Presumably, a high proportion of genetically controlled disease will be caused by or associated with SNPs. Research on SNPs has proceeded in two phases, (1) discovery by comparing DNA sequences of different individuals and (2) analysis by studying populations with or without a given trait. The second phase requires testing thousands of SNPs in hundreds of individuals and requires accurate, high throughput automated systems. The performance of these systems is enhanced by the compounds we have developed.
Gene Expression
Scientists study how gene expression affects development and contributes to health and illness by comparing the level of expression of genes in different tissues, in healthy versus diseased tissues, and at different points in embryonic development. This approach has been accelerated by the development of DNA microarrays, or biochips, which contain hundreds or thousands of sites on their surface to which messenger RNAs expressed by different genes will bind, allowing their relative levels to be tested and measured.
Hybridization Tests
Essentially all of the technologies and products useful for genetic analysis rely on hybridization, a process in which a synthetic DNA strand, called a probe, binds to a DNA target that is being detected. If the sequences of the two strands are perfectly complementary, the probe remains bound to its target at an elevated temperature. If they are not, the probe separates, or dissociates from its target. A hybridization assay is designed to detect the presence of the bound, or hybridized, probe to its nucleic acid target.
One of the greatest challenges facing scientists in developing hybridization tests is that the sequence of the target DNA can complicate the design of the probe. The process of choosing the optimum region on the target strand to which to attach the probe can be time-consuming and tedious. In multiplex formats, where multiple targets are being probed in the same test, designing probes that bind to their target at similar temperatures can further complicate the problem.
Our technologies facilitate genetic analysis by making the process of hybridization more efficient, hybridization tests simpler to design, and detection of the hybridized product easier.
Oligonucleotide Probes
A DNA probe is synthesized on an automated instrument and is designed to be complementary to a unique sequence of bases in the DNA of the target cell or organism. However, short DNA probes do not bind to their target very tightly, and longer DNA probes bind so tightly that they can hybridize to an incorrect sequence, or a mismatch. The ability to overcome these problems is the key to our technology.
We believe that the ability of DNA probes to precisely bind to matching DNA sequences will have broad use in the developing fields of molecular diagnostics and the study of genes. Applications that could benefit from improved hybridization sensitivity include:
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Accurate detection of mutations;
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Identifying infectious organisms, including measuring the level of HIV viruses in an individual’s bloodstream, and genotyping the virus to determine its resistance to therapy; and
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Diagnosing and determining the prognosis of cancers and their optimum therapies.
Epoch Technologies
We are an innovative biotechnology company that focuses on the development and manufacture of unique molecular tools for genetic analysis. Our expertise in nucleic acid chemistries has led to the development of patented compounds and methods that make the design, hybridization, and detection of DNA sequences easier and more accurate. Our technologies enhance the performance of synthetic DNA probes used extensively in genomic research and fall into the following categories:
MGB™
An MGB is a crescent shaped molecule that we attach to either end of a synthetic DNA probe. After hybridization, the MGB molecule folds into the minor groove of the double helix formed by the probe and its target DNA to stabilize the duplex structure and enable greater flexibility in experimental
design. The tight-binding MGB probes are especially useful for DNA detection using real-time PCR assay formats and are one of the important components of the MGB Eclipse Probe System as well as the Taqman® MGB product line sold by Applied Biosystems, a leading provider of real-time PCR technology.
Modified Bases
Nature’s four nucleotide bases - A, G, T, and C - and their sequence within DNA guide all cellular processes. Unfortunately the A-T and G-C content of genes can cause problems for genetic analysis. The bond between DNA probes and A/T rich sequences is inherently unstable, and to study A/T rich regions of the genome, researchers must use long primers and probes that are less sensitive to mismatches. G-rich sequences tend to clump together and are troublesome for scientists to work with. We’ve developed modified A, T, and G bases to solve these inherent problems for researchers, which are marketed under the brand names Super A™, Super T™, and Super G™.
Fluorescent Dyes and Quencher
To enable detection of DNA probes bound to their intended target, a variety of fluorescent dyes are used to “label” probes. We’ve developed a selection of proprietary fluorescent dyes for researchers to choose as labels for their custom probes, including Redmond Red™, Yakima Yellow™, and Gig Harbor Green™. In addition, to prevent fluorescence of labeled, but unbound probes, we’ve developed the Eclipse™ Dark Quencher, a proprietary quencher that’s widely used in the commercial marketplace.
Attachment Chemistry
DNA microarrays are another powerful technology platform for genetic analysis. Arrays of thousands of DNA probes on glass or plastic slides can be used to measure gene expression on a large scale. Although potentially powerful, current technology is highly variable and methods for array-making need improvement. We’ve developed attachment chemistry that enhances the binding of probes on glass or plastic slides and enables higher signal intensities for gene expression or SNP applications on microarrays.
Design Software
Each of the above technologies impact the performance characteristics of DNA probes and sophisticated algorithms are needed to drive the design and use of probes incorporating them. We’ve developed and continually enhance proprietary software to aid customers in the design, ordering, and use of certain of our products, such as MGB Eclipse™ Design Software for the online designing and ordering of custom MGB Eclipse Probe Systems.
Epoch Products
MGB Eclipse™ Probe Systems
In July 2001, we introduced the MGB Eclipse Probe System that incorporates the performance advantages of our proprietary technologies, including MGB, the Eclipse Dark Quencher, modified bases, and MGB Eclipse Design Software. The MGB Eclipse Probe System is compatible with all currently manufactured real-time PCR instruments and reagent systems in wide use worldwide, and provides highly effective and reproducible results for academic, biotech, diagnostic, and pharmaceutical
researchers. The MGB Eclipse Probe System is available in custom format so that researchers can design and order assays specific for their application and genetic sequence of interest as well as in the following pre-optimized formats:
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MGB Eclipse Probe Systems for Gene Expression, for determination of relative and absolute expression levels of specific genes, including detection of differentially spliced gene transcripts;
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MGB Eclipse Probe Systems for Viral Detection, for determination of viral titers and detection of variants in a real-time PCR format; and
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MBG Eclipse Probe Systems for Allelic Discrimination, which allows the use of short DNA probes to unambiguously discriminate single nucleotide polymorphisms (SNPs) or mutations with the ease of real-time PCR.
Custom Oligonucleotides
We manufacture and sell high quality, modified and purified custom synthetic oligonucleotides, or oligos, from our San Diego facility. We offer most standard modifications including biotin, fluorescent dyes, amine-linkers and phosphates. In addition, we offer more specialized modifications such as AP, HRP, Molecular Beacons, dual-labeled probes, RNA and 2’-O-methyl RNA.
Modified Bases, Florescent Dyes and Quencher
Our modified bases are part of the MGB Eclipse Probe System and Super G is available for sale in small quantities through distributors. Our fluorescent dyes and quencher are part of the MGB Eclipse Probe System and are also available for sale in small quantities through distributors and as optional modifications on our custom oligonucleotides.
Chemical Intermediates
For our collaborative partners, we manufacture chemical intermediates for incorporation into their products.
Sales and Marketing
We market and sell our products through a combination of direct sales personnel, worldwide distributors, and through collaborative relationships. To date, virtually all such efforts have been focused on the research market.
In July 2002, we named Amersham Biosciences our exclusive worldwide sales and marketing partner of MBG Eclipse Probe Systems to the research field for SNPs, and the co-exclusive worldwide sales and marketing partner to the research field for gene expression. Under terms of the distribution agreement, Amersham promotes and markets co-branded custom and catalogue MGB Eclipse products as part of its genomics product portfolio to researchers in the life science industry and to pharmaceutical companies conducting internal research. In October 2002, we named QIAGEN N.V. a co-exclusive worldwide sales and marketing partner to the research field for products that incorporate our MGB Eclipse Probe Systems for gene expression. We supply components to QIAGEN and QIAGEN will offer custom and catalogue probe systems as part of its gene expression product offerings to be launched in 2003. Under both agreements, our MGB Eclipse Design software is available from the partner’s website
to enable customers to rapidly design and order MGB Eclipse probes and primers specifically for a gene of interest.
We also sell our MGB Eclipse Probe Systems through cooperative marketing and supply programs with partners. As an example, in late 2001 we entered into an alliance with Incyte Genomics that, among other things, identifies us as Incyte’s preferred third party provider of unique, custom oligonucleotide probes and other proprietary hybridization probes to Incyte’s database users and provides for our supply of our MGB Eclipse Probe Systems to Incyte for Incyte’s internal development purposes.
We market and sell our specialty oligonucleotides through our small direct sales force that currently operates in the United States. We have marketed these products through advertisements in trade journals, direct mail, participation at industry trade shows, our website, and cooperative marketing and supply programs with partners.
We sell our fluorescent dyes, quencher, modified bases and other proprietary technologies worldwide through distributors such as Glen Research and Takara Bio. Our dyes and quencher are also supplied to Eurogentec S. A. for incorporation into custom oligonucleotides for sale in Europe through both its direct sales force and distributors.
We sell our chemical intermediates to collaborative partners for incorporation in their products pursuant to contractual supply agreements. For instance, we have granted licenses to use some of our genetic analysis technology to the Applied Biosystems division of Applera Corporation and Third Wave Technologies.
We currently have a small sales force and limited experience in marketing our products. Accordingly, we anticipate that we will enter into further distribution agreements with current and future product offerings to expand the geographical availability of our products.
We are currently in discussions with many companies and institutions to apply our products to their systems and projects. The companies include those engaged in developing automated research platforms for genetic analysis and those developing systems to be used in clinical diagnostic laboratories. Our corporate development personnel target leading pharmaceutical, biotech and diagnostic companies and research and academic institutions with the objective of entering into collaborative agreements. There can be no assurance that we will be able to enter into any additional collaborative arrangements on favorable terms or at all.
Our three largest customers in 2002 were Applied Biosystems, which accounted for 52% of our revenues, Amersham Biosciences, which accounted for 11% of our revenue, and Invitrogen, which accounted for 9% of revenues. Revenues from Invitrogen in 2002 were higher than in prior years because Invitrogen relocated one of its manufacturing facilities and significantly increased their orders to us during our second and third fiscal quarters. Late in 2002, Invitrogen orders slowed, and we currently expect revenues from this customer in 2003 to be less than in 2002. Our current business plan relies on the continuation of our relationship with Applied Biosystems and Amersham Biosciences and our business would be adversely affected if these relationships did not continue. See “Certain factors that may effect our business and future results” and the “Notes to Financial Statements” for more information about significant customers.
Currently, sales of our products are primarily to customers in the United States. As shipments pursuant to our worldwide distribution agreements increase, international sales can be expected to increase.
Manufacturing and Supply
We currently manufacture MGB Eclipse Probe Systems, modified bases, fluorescent dyes, quencher, and chemical intermediate products in our facility in Bothell, Washington, and produce specialty oligonucleotides at our facility in San Diego, California. Additionally, we use contract manufacturers to synthesize component chemical reagents when appropriate.
We purchase raw materials essential to our business in the ordinary course of business from numerous suppliers. Substantially all the raw materials used for our commercial manufacturing of oligonucleotides, assay systems and other reagent products are available from multiple sources; however, other raw materials for supply contract and OEM manufacturing are proprietary products of other companies. Raw materials may be rejected if they do not meet manufacturing specifications, are contaminated and/or have other failures. A material shortage, contamination, or failure could adversely impact the commercial manufacturing of our products and related revenues.
We have sufficient manufacturing capacity to meet current customer needs. Anticipated increases in customer demand over the next year may require us to expand our manufacturing capacity in Bothell, acquire additional manufacturing capacity, or utilize costly third-party manufacturing vendors, as necessary. We are currently negotiating for a relatively small amount of additional space immediately adjacent to our Bothell facility which would be held as shell space for future expansion, however we cannot provide assurance that we will be able to successfully negotiate a lease on that space. We are also exploring opportunities to consolidate our manufacturing operations in Bothell.
Research and Development
We conduct the majority of our research and development activities through our own staff and facilities. Our goal is to improve DNA technology thereby making biotechnology, molecular biology and diagnostics more robust. We have assembled a scientific staff with a variety of complementary skills in a broad range of advanced research technologies, representing molecular biology, biochemistry, physical chemistry, and synthetic chemistry. As of December 31, 2002, we had 27 employees engaged in developing our technology and applying it to genetic analysis, including 14 with Ph.Ds. Our in-house research and development efforts are focused primarily on the development of improvements in DNA synthetic chemistry, hybridization reproducibility and ease of use, and detection technologies. This research and development focus will further our efforts to commercialize DNA probes, DNA bases, probe labeling, detection techniques and reagent chemistries. In addition to our in-house research programs, we collaborate with academic and research institutions to support research in areas of interest to us.
Our research and development expenses were $3,468,000 in 2000, $4,834,000 in 2001, and $4,677,000 in 2002.
Patents and Proprietary Technology
As of February 15, 2003, our core technologies were covered by fifteen issued patents, and we have filed twenty additional patent applications in the United States. To our knowledge, there are no competing patents on our technology. The expiration dates of these patents range from January 2010 to July 2020.
The patent position of biomedical companies, including our own, is uncertain and may involve complex legal and factual issues. Consequently, we do not know whether any of our patent applications will result in the issuance of any further patents, or whether issued patents will provide significant proprietary protection or will not be circumvented or invalidated. We cannot be certain that we were the first creator of inventions covered by pending patent applications or that we were the first to file patent applications for such inventions, largely because patent applications in the U.S. are maintained in secrecy until the patents issue, and because publications of discoveries in the scientific or patent literature tend to lag behind actual discoveries by several months. Moreover, we may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office to determine the priority of inventions, which could result in substantial costs. We cannot provide assurance that our patent applications will result in further issued patents or that our issued patents will offer protection against competitors with similar technology. Additionally, we cannot provide assurance that any manufacture, use or sale of our technology or products will not infringe on patents or proprietary rights of others, and we may be unable to obtain licenses or other rights to these other technologies that may be required for the commercialization of our proposed products.
We require our employees, consultants and advisors to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. Each agreement provides that all confidential information developed or made known to the individual during the course of the relationship will be kept confidential and not disclosed to third parties except in specified circumstances. In the case of employees, the agreements provide that all inventions conceived by an individual shall be our exclusive property, other than inventions unrelated to our business and developed entirely on the employee’s own time. We cannot provide assurance, however, that these agreements will provide meaningful protection or adequate remedies for misappropriation of trade secrets in the event of unauthorized use or disclosure of this information.
Competition
The markets for our technologies and products are very competitive, and we expect that competition to continue for the foreseeable future. We compete primarily with other companies that are pursuing technologies and products that provide alternatives to our technologies and products. In the research market, there are more than 20 competitors in the development, manufacturing and marketing of reagents for genetic analysis, including the detection of infectious diseases using a variety of technologies and specialty oligonucleotides, most of which are larger than us. There are many pharmaceutical, diagnostic and biotechnology companies, public and private universities and research organizations engaged in the research and development of diagnostic products. Most of these organizations have financial, manufacturing, marketing and human resources greater than ours.
Regulation
We currently sell our products to researchers or to partners whose end customers are researchers. As such, our current products are not subject to regulation by the United States Food and Drug Administration. However, Epoch is subject to the regulations of various other federal and state agencies. We believe we are in compliance in all material respects with the regulations promulgated by the agencies which govern us, and that such compliance has not had, and is not expected to have, a material adverse effect on our business.
We also believe that our operations comply in all material respects with applicable environmental laws and regulations. Such compliance has not had, and is not expected to have, a material adverse effect on our capital expenditures, results of operations or competitive position.
Insurance
We carry property and general liability insurance, product liability insurance, and director and officers liability insurance in amounts and on terms deemed adequate by management. Future claims could, however, exceed our applicable insurance coverage.
Employees
As of December 31, 2002, we had 67 full-time employees, of which 23 were devoted to manufacturing, 27 were devoted to research and development activities, 5 to sales and marketing, and 12 were devoted to general and administrative activities. At December 31, 2002, 36 employees worked in our Bothell facility and 31 worked in our San Diego facility. We believe we have been successful in attracting skilled employees with experience in the biomedical industry, but we cannot provide assurance that we will continue to do so in the future. None of our employees are covered by a collective bargaining agreement, and management considers relations with its employees to be good.
Availability of SEC Filings
All reports filed by the Company with the SEC are available free of charge via EDGAR through the SEC website at www.sec.gov. In addition, the public may read and copy materials filed by the Company with the SEC at the SEC’s public reference room located at 450 Fifth St. N.W., Washington, D.C., 20549. Information regarding operation of the SEC’s public reference room can be obtained by calling the SEC at 1-800-SEC-0330. The Company also provides copies of its Forms 8-K, 10-K 10-Q, Proxy and Annual Report at no charge to investors upon request and makes its reports available through its website at www.epochbio.com, as soon as reasonably practicable after filing such material with the SEC.
Certain Factors That May Affect Our Business And Future Results
Forward Looking Statements
Some of the information included herein contains forward-looking statements. These statements can be identified by the use of forward-looking terms such as “may,” “will,” “expect,” “anticipates,” “estimate,” “continue,” or other similar words. These statements discuss future expectations, projections or results of operations or of financial condition or state other “forward-looking” information. When considering these forward-looking statements, you should keep in mind the risk factors and other cautionary statements we make. These risk factors could cause our actual results to differ materially from those contained in any forward-looking statement. If any of the following risks actually occur, our business could be harmed and the trading price of our common stock could decline.
We may be unable to maintain our listing on Nasdaq, which could cause our stock price to fall materially and decrease the liquidity of our common stock
Our common stock is currently listed on The Nasdaq SmallCap Market. To maintain the listing, we must continue to satisfy the ongoing Nasdaq compliance requirements, including that our common stock have a minimum bid price of $1.00 per share. In the third and fourth quarters of 2002 our stock traded below the $1 minimum for a few days.
If our common stock is delisted from trading on The Nasdaq SmallCap Market and is not relisted thereon we would likely seek listing of our common stock on the over-the-counter market, which is viewed by many investors as a less liquid marketplace. As a result, the price per share of our common stock would likely decrease materially and, the trading market for our common stock, our ability to issue additional securities and our ability to secure additional financing would likely be materially and adversely affected.
We have been profitable in only one quarter and anticipate future losses, and we may require additional capital
Since our formation in 1985, we have generated limited revenues and only realized one profitable quarter, which was the quarter ended December 31, 2002. As of December 31, 2002, we had an accumulated deficit of approximately $74 million. While we are commercializing our products and technologies, prior to adequate revenues being generated from these activities we expect to incur additional losses as we expand our manufacturing capacity, continue our research and development activities and fund our product commercialization efforts. There is no assurance that we will ever become profitable or that we will sustain profitability if we do become profitable. Should we experience continued or unforeseen operating losses, our capital requirements would increase and our stock price would likely decline.
Additionally, as of December 31, 2002 we had approximately $3.5 million in cash and cash equivalents and have a commitment from a bank for a secured term loan of $2,500,000 of which $847,000 has been drawn, and also a working capital line of credit of $750,000 which has not been drawn upon. We currently anticipate that our current cash balances, cash from operations, and unused borrowing capacity will be sufficient to meet our cash needs through at least the next twelve months. However, we may need to seek additional equity and/or debt capital, and there can be no assurance that such capital will be available to us on favorable terms, or at all. If additional funds are not available, we would be required to delay, reduce, or eliminate expenditures for some or all of our programs or products.
There is a risk that our technology may not be effective or might not work
The science and technology of synthetic DNA-based products is rapidly evolving. While we are beginning to produce and supply products to customers for commercial use, the majority of our products and proposed products are in the discovery or early development stage. The proposed products will require significant further research, development, and testing. We face the risk that any or all of our products and proposed products could prove to be ineffective or unsafe, or be an inferior product to products marketed by others because our products are based on new and unproven innovative technologies. Some of our current research and development activities may not result in any commercially viable products. If we do not have commercially viable products, we will not be able to sell our products, we will not be able to attract partners, and we will not be able to generate funds internally to support operations.
We have limited manufacturing experience
While we have experience in researching and developing unique, proprietary technologies to enhance the study of genes, and in manufacturing oligonucleotides at relatively small scales, our experience in manufacturing other chemical reagent products is relatively limited. We have sufficient manufacturing capacity to meet current customer needs. Anticipated increases in customer demand over the next year may require us to expand our manufacturing capacity in Bothell, acquire additional
manufacturing capacity, or utilize costly third-party manufacturing vendors, as necessary. Any delay or inability to expand our manufacturing capacity could materially adversely affect our manufacturing ability.
There is a risk that we do not own exclusive rights to our technology, or that our competition may have access to our technology which may prevent us from selling our products
We attempt to protect our proprietary technology by relying on several methods, including United States patents. We also have international patent applications that correspond to many of the U.S. patents and patent applications. The issued patents and pending patent applications cover inventions relating to the components of our core technologies. The expiration dates of these patents range from January 2010 to July 2020. We make no guarantee that any issued patents will provide us with significant proprietary protection, that pending patents will be issued, or that products incorporating the technology covered by our issued patents or pending applications will be free from challenges by competitors. Further, third parties may hold proprietary rights which precede our claims and could therefore prohibit us from marketing the proposed products.
Some of our technology might infringe on the rights of others, which may prevent us from selling our products
There is a great deal of litigation regarding patents and other intellectual property rights in the biomedical industry. We were defendants in one action of this kind, which we settled prior to 1997. Although patent and intellectual property disputes in the biomedical area are sometimes settled through licensing or similar arrangements, this kind of solution can be expensive, if a license can be obtained at all. An adverse determination in a judicial or administrative proceeding or our failure to obtain necessary licenses could prevent us from manufacturing and selling our products. This would substantially hurt our business.
We face numerous competitors and changing technologies which could make our products obsolete
Many companies do research and development and market products designed to analyze genes and diagnose conditions based on a number of technologies and are developing additional products. Many of these companies have substantially greater capital resources, larger research and development and marketing staffs and facilities and greater experience in developing products than we have. Furthermore, the specific field in which we operate is subject to significant and rapid technological change. Even if we successfully introduce our products or proposed products, our technologies could be replaced by new technologies or our products or proposed products might be obsolete or non-competitive.
We will be dependent upon our agreement with Applied Biosystems for a significant portion of our revenues for 2003, and a reduction of sales under or early termination of this agreement would seriously harm our revenues and operating results and would likely cause our stock price to decline
In January 1999, Epoch and Applied Biosystems entered into a License and Supply Agreement pursuant to which we licensed some of our technology to Applied Biosystems for use in its TaqMan® 5’-nuclease real-time PCR assays, or tests (TaqMan® is a registered trademark of Roche Molecular Systems, Inc.). In July 1999, we licensed our proprietary software, which speeds the design of oligonucleotide probes used in the study of genes, to Applied Biosystems. In August 2000, the agreement was amended to, among other things, provide for Epoch manufacturing product for Applied Biosystems. In July 2002
this agreement was further amended to remove the manufacturing rights from the contract effective October 2002, redefine product categories, increase the minimum royalties and royalty rates, and establish that minimum royalties are measured and paid quarterly. We will depend upon product sales and royalties from Applied Biosystems’ sales of its TaqMan® assays under this agreement for a significant portion of our revenues in 2003 and future periods.
Either party may terminate the agreement upon 180 days written notice. In the event that this agreement is terminated, our revenues, financial condition and operating results would be adversely affected and our stock price would likely decline.
We will be dependent on our agreements with Amersham Biosciences and QIAGEN N.V. for the distribution of our MGB Eclipse products and the resultant revenues. Lower than expected sales, or early termination of these agreements would seriously harm our projected revenues and operating results and would likely cause our stock price to decline.
In July 2002, Epoch and Amersham Biosciences entered into an agreement under which Amersham became the exclusive worldwide sales, marketing and distribution partner to the research field of our MGB Eclipse Probe Systems for SNPs, and the co-exclusive worldwide sales and marketing partner to the research field for gene expression.
In October 2002, Epoch and QIAGEN entered into a license and supply agreement under which QIAGEN became the co-exclusive worldwide sales, marketing and distribution partner to the research field of our MGB Eclipse Probe Systems for gene expression.
We will depend upon product sales to Amersham and QIAGEN under these agreements for a significant portion of our revenues in future periods. In the event that either of these agreements is terminated, or either partner is unsuccessful at commercializing our technologies, our revenues, financial condition and operating results would be adversely affected and our stock price would likely decline.
Some of our customers may experience financial difficulties, which could adversely impact our collection of accounts receivable
Although historically we have experienced limited credit losses from our trade receivables, our experience is limited. At December 31, 2002, our allowance for doubtful accounts was $32,000. We regularly review the collectibility and credit worthiness of our customers and the receivables to determine an appropriate allowance for doubtful accounts, however future uncollectible accounts could exceed our current or future allowances.
The loss of key personnel could adversely affect operations by impairing our research and our efforts to commercialize and license our products
Our performance is greatly dependent upon our key management, including our Chief Executive Officer, Dr. William Gerber, and technical personnel and consultants. Our future success will depend in part upon our ability to retain these people and to recruit additional qualified personnel. We must compete with other companies, universities, research entities and other organizations in order to attract and retain highly qualified personnel. Although we have entered into agreements with our key executive officers, we make no guarantee that we will retain these highly qualified personnel or hire additional qualified personnel. We currently maintain no key man life insurance on any of our management or technical personnel.
The value of our common stock could change significantly in a very short time
The market price of our common stock may fluctuate significantly. For example, in the year 2002 our stock traded as high as $2.72 in January, and as low as $0.70 in October. The rapid price changes Epoch has experienced recently, and throughout our history, place your investment in our common stock at risk of total loss over a short period of time. We are in the biotechnology industry and the market price of securities of biotechnology companies have fluctuated significantly and these fluctuations have often been unrelated to the companies’ operating performance. Announcements by us or our competitors concerning technological innovations, new products, proposed governmental regulations or actions, developments or disputes relating to patents or proprietary rights, and other factors that affect the market generally could significantly impact our business and the market price of our securities.
Public opinion regarding ethical issues surrounding the use of genetic information may adversely affect demand for our products
Public opinion regarding ethical issues related to the confidentiality and appropriate use of genetic testing results may influence governmental authorities to call for limits on, or regulation of the use of, genetic testing. In addition, these authorities could prohibit testing for genetic predisposition to certain conditions, particularly for those that have no known cure. Furthermore, adverse publicity of public opinion relating to genetic research and testing, even in the absence of any governmental regulation, could harm our business. Any of these scenarios could reduce the potential markets for our products and technologies, which could materially and adversely affect our revenues.
Government regulation of genetic research or testing may adversely affect the demand for our products and impair our business and operations
Federal, state and local governments may adopt regulations relating to the conduct of genetic research and genetic testing. These regulations could limit or restrict genetic research activities as well as genetic testing for research or clinical purposes. In addition, if state and local regulations are adopted, these regulations may be inconsistent with, or in conflict with, regulations adopted by other state or local governments. Regulations relating to genetic research activities could adversely affect our ability to conduct our research and development activities. Regulations restricting genetic testing could adversely affect our ability to market and sell our products and our technologies. Accordingly, any regulations of this nature could harm our business.
Health care cost containment initiatives could limit the adoption of genetic testing as a clinical tool, which would harm our revenues and prospects
In recent years, health care payers as well as federal and state governments have focused on containing or reducing health care costs. We cannot predict the effect that any of these initiatives may have on our business, and it is possible that they will adversely affect our business. In particular, gene-based therapeutics, if successfully developed and commercialized, are likely to be costly compared to currently available drug therapies. Health care cost containment initiatives focused either on gene-based therapeutics or on genetic testing could cause the growth in the clinical market for genetic testing to be curtailed or slowed. In addition, health care cost containment initiatives could also cause pharmaceutical companies to reduce research and development spending. In either case, our business and our operating results would be harmed.
ITEM 2.
ITEM 2. Properties
Our principal administrative office and research laboratories are located in Bothell, Washington, where we lease and occupy approximately 25,000 square feet. We also manufacture chemical intermediates and MGB Eclipse Probe Systems at our Bothell facility. The current lease was initiated in February 2000 when we entered into a 12-year non-cancelable lease for space within a multi-tenant property which we initially occupied in November 2000.
Our specialty oligonucleotide manufacturing facility is located in San Diego, California, where we lease and occupy approximately 8,200 square feet. The current lease term on this property expires in November 2005, but is terminable at any time with 90 days written notice.
We are currently exploring opportunities to consolidate our manufacturing operations in Bothell.
ITEM 3.
ITEM 3. Legal Proceedings
Mordecai Jofen, as Trustee of the Harbor Trust, f/k/a The Edward Blech Trust v. Epoch Biosciences, Inc., United States District Court for the Southern District of New York, Case No. 01 CV 4129
The Harbor Trust (formerly the Edward Blech Trust) filed a complaint against us, alleging the breach of a 1996 letter agreement between us and David Blech. Pursuant to the letter agreement, upon payment of a pre-existing debt owed to us by Blech (the “Ribonetics Debt”), we were to release to Blech from escrow warrants to purchase 500,000 shares of our stock. Blech assigned all of his rights under the letter agreement to the Harbor Trust. The Harbor Trust’s claim is based on our alleged failure to timely register the common stock underlying the warrants, allegedly resulting in damages to Blech and/or the Harbor Trust of at least $10 million, based on the peak trading value of our stock.
We filed a motion to dismiss the complaint based on, among other things, the positions that: (1) Blech and the Harbor Trust have never had rights to receive or exercise the warrants because Blech failed to perform a condition precedent, i.e., payment of the Ribonetics Debt; and (2) we had no obligation to register the stock unless and until Blech was entitled to the warrants. Further, the warrants expired pursuant to the letter agreement in June 2000. The Court granted our motion to dismiss in November 2001, but gave the Harbor Trust leave to file an amended complaint, which they filed in December 2001. We filed a motion to dismiss the amended complaint in January 2002. In July 2002, the Court decided in our favor and granted the motion to dismiss without leave to file an amended complaint.
In August 2002 the Harbor Trust appealed the Court’s dismissal of its case to the United States Court of Appeal for the Second Circuit. The appeal is likely to be resolved in the second quarter of 2003. While we believe we have a strong position, it is not possible at this time to state the likelihood of an unfavorable outcome because of the inherent uncertainties of litigation.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 2002.
PART II
ITEM 5.
ITEM 5. Market for Common Equity and Related Stockholder Matters
On February 4, 2003, our common stock began trading on The Nasdaq SmallCap Market under the symbol “EBIO.” From May 10, 2000 through February 3, 2003, our common stock traded on The Nasdaq National Market under the symbol “EBIO.” The table below presents information on the high and low trading prices of our common stock.
On March 20, 2003, the last reported sale price for our common stock on the Nasdaq SmallCap Market was $1.56 per share. As of March 20, 2003, there were approximately 3,140 stockholders of record of our common stock. We have not paid any dividends on our common stock since our inception and do not anticipate paying any dividends in the foreseeable future. Any earnings generated in the foreseeable future will be used for the further expansion of the business.
Recent Sales of Unregistered Securities
The following is a summary of our transactions during 2002 involving sales of our securities that were not registered under the Securities Act. Exemption from the registration requirements of the Securities Act for the sales of the securities described below was claimed under Section 4(2) of the Securities Act, among others, on the basis that such transactions did not involve any public offering and the purchasers were sophisticated with access to the kind of information registration would provide. No underwriting or broker’s commissions were paid in connection with the following transaction.
In January 2002, we issued a five-year warrant to purchase 15,000 shares of our common stock at $2.53 per share to a professional services provider to the company. The shares vested in equal monthly installments over one year.
ITEM 6.
ITEM 6. Selected Financial Data
The information set forth below should be read in conjunction with Item 7
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and related notes included elsewhere in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in the forward-looking statement as a result of factors including, but not limited to, those set forth in “Certain factors that may affect our business and future results” and elsewhere in this report.
Overview
Epoch develops technology and products that enable and accelerate genomic analysis. The foundation of our business strategy is the continued funding of innovative research and development and commercialization of the resultant products through a number of channels.
We earn revenues through a variety of sources. We license our technology for incorporation into other companies’ products and generate product revenue and earn license fees and royalties from those
companies. We also sell our products to end-users; both through our direct sales force and through distributors that provide worldwide reach. We also earn revenues through contract research activities, whereby third party companies pay for specific research and development activities carried out by our scientists.
In January 1999, Epoch and Applied Biosystems entered into a License and Supply Agreement pursuant to which we licensed some of our technology to Applied Biosystems for use in TaqMan® 5’-nuclease real-time PCR assays, or tests. Under the terms of the agreement, Applied Biosystems’ made payments to us of initial fees for licensed technology and proprietary know how, and will make ongoing payments for purchases of chemical compounds as well as royalties on sales of product which use the licensed technology, subject to minimums.
In July 1999, we licensed our proprietary software, which speeds the design of chemical tools used in the study of genes, to Applied Biosystems. This agreement increased the scope of the licensing agreement entered into in January 1999 with Applied Biosystems to include software that allows for the efficient custom design of Taqman® probes, which are chemical compounds which seek out, or “probe” for a specific location on a gene, by the end user. The software is incorporated into Applied Biosystems’ Primer Express™ software which is sold with its 7700 Sequence Detection System. In addition to license fees, we receive royalties on all products that Applied Biosystems sells which incorporate the software.
In November 1999, Applied Biosystems converted $1,000,000 of prepayments made by it pursuant to the License and Supply Agreement into 400,000 shares of our common stock. In order to secure any unused portion of the purchased product prepayments (up to $450,000), we continued to grant to Applied Biosystems a security interest in the patents related to the technology under the terms of a security agreement. The security interest automatically terminates when any unused portion of the purchased product prepayments is $50,000 or less. Although no security interest was granted with respect to the royalty prepayments, if the royalty payments do not become due under the agreement, we will also be required to refund any unused prepayments to Applied Biosystems, which approximates $100,000 at December 31, 2002.
In August 2000, the agreement was amended to include research and development funding of $1,000,000 per year, subject to adjustment under terms of the agreement. This portion of the agreement expired in August of 2002, and we are not currently doing research work for Applied Biosystems.
In October 2001, we further amended our agreement with Applied Biosystems. Under the terms of this amendment, Applied Biosystems paid us a minimum amount each quarter for their right to order, and our obligation to manufacture, probes for them. This amendment was effective from October 2001 through October 2002. In July 2002, a further amendment removed the manufacturing rights from the contract effective October 2002, redefined product categories, increased the minimum royalties and royalty rates, and established that minimum royalties are measured and paid quarterly.
Under the terms of the agreement, if Applied Biosystems terminates the agreement upon 180 days written notice to us, or if we terminate the agreement following a material breach by Applied Biosystems, Applied Biosystems will release its security interest in the patents and forfeit any unused portion of the prepayments. However, if we and Applied Biosystems mutually agree to terminate the agreement, or if Applied Biosystems terminates the agreement as a result of a material breach by us, then we must reimburse Applied Biosystems the difference between the unused portion of the purchased product prepayments and $50,000, which approximates $100,000 at December 31, 2002.
In October 2000, we entered into a Development, License and Supply Agreement with Third Wave Technologies whereby we licensed our proprietary fluorescent dye and quencher technologies to Third Wave. Third Wave also has the option to license other proprietary chemistries we have, in which case additional license and royalty fees would be due to us. We received an initial license fee which is being amortized over the life of the contract and we receive royalties on sales of Third Wave products which include the licensed technology. Included in the agreement with Third Wave was a collaborative research effort to be funded by Third Wave through December 31, 2003. In 2002 Third Wave informed us that it was ceasing funding development with us. We instituted arbitration proceedings against Third Wave and in March 2003 agreed that Third Wave would no longer be obligated to fund development. In exchange, Third Wave agreed to pay us $300,000 of which $85,000 was included in accounts receivable at December 31, 2002, and Third Wave also agreed to higher annual minimum royalties under its license from us for dye and quencher technologies.
In November 2000, we acquired some of the assets and liabilities of Synthetic Genetics, a San Diego, California manufacturer of specialty oligonucleotides for approximately $3,788,000 including $3,425,000 in cash paid, the direct costs of the acquisition, and the assumption of liabilities. The acquisition provided us with manufacturing capacity to meet anticipated order volumes generated by the Applied Biosystems contract. The acquisition was accounted for as a purchase of a business and resulted in the recognition of goodwill of approximately $2,321,000 and other intangibles of approximately $1,119,000.
In July 2001, we launched our MGB Eclipse Probe System, that incorporates the performance advantages of our unique MGB and MGB Eclipse Dark Quencher technologies. MGB Eclipse probe assays are compatible with all currently manufactured real-time PCR systems, and provide highly effective and reproducible results for academic, biotech, diagnostic and pharmaceutical researchers. The initial release consisted of MGB Eclipse probes for gene expression, viral detection, and allelic discrimination for single nucleotide polymorphisms (SNP’s).
In October 2001, we entered into a license, development, and supply alliance with Incyte Genomics, Inc. The alliance consists of three elements. First, we will receive access to the gene sequence content from Incyte’s LifeSeq Gold® and ZooSeq® databases for use in the design, manufacture, and sale of MGB Eclipse probe products. Second, under the alliance we will be identified as the preferred provider of custom oligonucleotides and other proprietary hybridization probes to Incyte’s users of LifeSeq Gold. Third, we will supply Incyte with MGB Eclipse Probe Systems for their internal development purposes.
In July 2002, we named Amersham Biosciences our exclusive worldwide sales and marketing partner of MBG Eclipse Probe Systems to the research field for SNPs, and the co-exclusive worldwide sales and marketing partner to the research field for gene expression. Under terms of the distribution agreement, Amersham promotes and markets co-branded custom and catalogue MGB Eclipse products as part of its genomics product portfolio to researchers in the life science industry and to pharmaceutical companies conducting internal research. In October 2002, we named QIAGEN N.V. a co-exclusive worldwide sales and marketing partner to the research field for products that incorporate our MGB Eclipse Probe Systems for gene expression. We supply components to QIAGEN and QIAGEN will offer custom and catalogue probe systems as part of its gene expression product offerings to be launched in 2003. Under both agreements, our MGB Eclipse Design software is available from the partner’s website to enable customers to rapidly design and order MGB Eclipse probes and primers specifically for a gene of interest. Both of these agreements are restricted to the research field. We retain all other rights to MGB Eclipse Probe Systems in other fields, including diagnostics, bioterroism, and bio-warfare.
We expect to incur operating losses for at least the next year as we continue research and development spending in applying our synthetic DNA-based technology to genomic analysis to the research and other fields, and incur costs commercializing the resultant products through various channels.
Critical Accounting Policies
Our accounting policies are more fully described in Note 1 to our financial statements. However, certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. As a result they are subject to an inherent degree of uncertainty. In applying those policies, our management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts, our observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. Our critical accounting policy is revenue recognition.
Revenue recognition. We earn revenues from product sales of chemical products and reagents to manufacturers for incorporation into their products, from the sale of specialty oligonucleotides and value added reagents to end users and distributors in the research fields of genomics and molecular diagnostics, from license fees for the use of our proprietary technology and know-how, and by providing services to third parties for performing research and development on their behalf. We also have product royalty agreements that result in royalties to us upon ultimate sales of products by our partners.
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Revenues from product sales that require no ongoing obligations are recognized when shipped to the customer and title has passed. To the extent that sales are made to distributors and not sold through to end users our future sales could decline.
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License fees are recognized over the term of the agreement to which the license fees correspond, which may extend to the expiration of the underlying patents, and based on the terms and future performance obligations in the underlying agreements. These upfront fees are generally nonfundable regardless of future performance. Deferred revenue principally represents these license fees received in advance and prepayments for product purchases.
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Contract research revenues are recognized as the research and development activities are performed under the terms of commercial collaboration and supply agreements and government grants. Direct costs related to these contracts and grants are reported as research and development expenses.
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Royalty revenues are recognized when earned under the terms of the related agreements, which is generally upon sale of products by our partner containing our component products. To the extent our partners no longer use our component products or sales of their products are less than expected, our royalty revenues could decrease in the future.
Results of Operations
2002 vs. 2001
Revenues for the year ended December 31, 2002, increased 49% over 2001, primarily due to increases in product sales and royalties.
Product Sales. Product sales include sales of specialty oligonucleotides to end users and our distribution partners in the research market and sales of chemical intermediates and our dyes, quencher, and modified bases to collaborative partners and distributors. Product sales increased to $6,662,000 in 2002 from $4,461,000 in 2001, reflecting increased sales of MGB Eclipse Probe Systems, including initial shipments to worldwide marketing partners Amersham Biosciences and QIAGEN, and increases in sales of other custom oligonucleotides and chemical intermediates to corporate partners.
Revenue from the sale of specialty oligonucleotides grew significantly in 2002 for three primary reasons. First, sales of MGB Eclipse Probe Systems increased due to a full year of shipments to Incyte and initial shipments in the third and fourth quarters to Amersham and QIAGEN pursuant to our distribution agreements. In 2001, we had limited revenue from Incyte and no shipments to Amersham or QIAGEN. Second, one of our major customers for specialty oligonucleotides relocated one of its manufacturing facilities during the year and outsourced the work to us during the move. We had sales of approximately $1,005,000 from this customer in 2002 and we do not currently expect to receive this level of sales in 2003. Third, revenues from Applied Biosystems for MGB TaqMan probe manufacturing increased. These manufacturing rights ceased in September 2002 pursuant to the most recent amendment to that agreement, with the value of those rights recharacterized as product royalties.
Chemical intermediate revenues represent component chemistries that we supply on cost-plus terms for incorporation in our partners’ products and sales of our dyes, quencher, and modified bases through distributors. These revenues increased 39% in 2002 as a result of growth in our shipments to Applied Biosystems in support of their Assays-on-Demand™ and Assays-by-Design™ product launches. Initial shipments of our dyes, quencher, and modified bases to our new distribution partners also contributed to the increase in these revenues.
License Fees and Royalty Income. License fees reflect the amortization of initial payments for technology and know-how transfers. These amounts are amortized over the life of the contract. Royalty
income represents the royalty amounts under license agreements. License fees and royalty income increased to $2,694,000 in 2002 from $936,000 in 2001 as the result of higher product sales by corporate partners and contractual minimums. In the fourth quarter of 2002, we received the last annual minimum royalty payment from Applied Biosystems under the agreement in effect through September 30, 2002. Also during that quarter, we accrued the first quarterly minimum royalty amount pursuant to the amended agreement that became effective October 1, 2002. The resultant recognition of two minimum royalty amounts from Applied Biosystems in the same quarter is unlikely to recur. While the quarterly minimum royalty amounts from Applied Biosystems increase modestly quarter over quarter under the amended agreement, we expect quarterly royalties from Applied Biosystems in 2003 to be less than we recognized in the fourth quarter of 2002.
Contract Research Revenue. Contract research revenue primarily reflects payments for contract research and development performed for our corporate partners. Contract research revenues decreased from $2,124,000 in 2001 to $1,870,000 in 2002 due to the expiration of the Applied Biosystems research contract in August 2002 and suspended activity in the Third Wave Technologies research contract in April 2002, offset by increases in funded research activities that centered on applications for our MGB Eclipse technologies.
Cost of Product Sales. The cost of product sales represents the manufacturing costs of material, labor and overhead allocations associated with product sales. Also included is the cost of outside manufacturers which we use to produce some of our chemical intermediates. The cost of product sales increased to $4,144,000 in 2002 compared to $3,092,000 in the prior year. Costs as a percentage of product sales decreased from 69% in 2001 to 62% for the current year.
Increases in costs of product sales are generally tied to the increases in revenues, while the changes in costs as a percentage of product sales are generally impacted by the product mix and economies of scale resulting from higher volumes. The selling prices of our chemical intermediates, for example, are determined by contracts and are tied to fully burdened manufacturing costs, which means our gross margin is fixed at levels below those generally found in the commercial marketplace.
The decrease in costs as a percentage of product sales experienced in 2002 is the result of three factors: 1) economies of scale driven by the increase in product sales; 2) a different product mix, specifically higher MGB Eclipse revenues; and 3) the impact of changes in manufacturing processes which are resulting in lower costs.
Research and Development. Research and development costs decreased $157,000, or 3%, in 2002 compared to 2001. Significant changes in research and development costs were impacted by:
purchases of raw materials which were primarily attributable to chemical intermediate manufacturing.
Selling, General and Administrative. Selling, general and administrative expenses increased $1,122,000, or 24%, in 2002 over 2001. The increase in 2002 was primarily the result of:
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Selling and marketing expenses increased $704,000 as we continued our efforts to establish MGB Eclipse Probe Systems and gain product market share in the specialty oligonculeotide field through the addition of sales and product marketing personnel and print advertising programs.
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Licensing expenses increased $261,000 resulting from our increased royalty revenues.
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Personnel costs increased $139,000 in our San Diego facility as we changed staffing to meet customer needs, including the addition of a Vice President of Operations.
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Legal expenses increased $98,000 during the year for various general corporate matters including the completion of agreements with Amersham and QIAGEN.
Interest Income, net. Interest income, net, in 2002 was lower than 2001 due to reduced cash balances available for investment, lower interest rates, and higher interest expense as a result of our new term loans to Silicon Valley Bank in late 2002.
2001 vs. 2000
Product Sales. Product sales began in 2000 and represent the sale of chemical intermediates and probes, primarily to collaborative partners, and the sale of specialty oligonucleotides to the research market from our San Diego facility.
Chemical intermediate revenues, primarily to Applied Biosystems and Third Wave Technologies, represent component chemistries that we supply on cost-plus terms for incorporation in our partners products. These revenues increased in 2001 as a result of growth in our shipments to Applied Biosystems, and the start of shipments to Third Wave.
Revenue growth in our specialty oligonucleotide business grew significantly in 2001 for two primary reasons. First, revenues from the TaqMan® MGB probes and other products manufactured for Applied Biosystems pursuant to our License and Supply Agreement, as amended, began in early 2001. Second, because of the acquisition of Synthetic Genetics in November 2000, calendar 2001 results include sales of specialty oligonucleotides for a complete twelve month year, while 2000 results includes only six weeks specialty oligonucleotide sales.
License Fees and Royalty Income. License fees reflect the amortization of initial payments for technology and know-how transfers. These amounts are amortized over the life of the contract. Royalty income represents the royalties received under license agreements. Royalties in 2001 increased significantly over the prior year as a result of increased sales of products incorporating our technologies by our licensees and receipt of contractual minimum payments during the year.
Contract Research Revenue. Contract research revenue in 2000 reflects payments for contract research and development performed under the Applied Biosystems’ agreement for four months of the year. In 2001, contract research revenue primarily reflects contract research under our agreements with Applied Biosystems and Third Wave Technologies for the full year.
Cost of Product Sales. The cost of product sales represents the direct manufacturing costs of material, labor and overhead allocations associated with product sales. Also included is the cost of outside manufacturers which we use to produce some of our chemical intermediates. The increased costs in 2001 are attributable to the increase in product sales and changes in the product mix due to the addition of our San Diego operations and increased volumes of chemical intermediates at contractual margins.
Research and Development. Research and development costs increased $1,366,000, or 39%, in 2001 over 2000. This increase was primarily driven by:
Selling, General and Administrative. Selling, general and administrative expenses increased $1,212,000, or 36%, in 2001 over 2000. The increases in 2001 were primarily the result of:
Interest Income, net. Interest income, net, in 2001 was lower than 2000 due to reduced cash balances available for investment coupled with lower interest rates in 2001. Interest expense in 2000 and 2001 are minimal and represent the interest payments under capital leases which were assumed as part of the Synthetic Genetics acquisition.
Liquidity and Capital Resources
At December 31, 2002 we had operating cash and cash equivalents of $3,508,000, compared to $7,489,000 at December 31, 2001, a decrease of $3,982,000.
In 2002, cash used in operations totaled $3,895,000, basically representing our decrease in cash for the year. Within operations, our net loss of $3,216,000 and the aggregate change in working capital accounts of $1,517,000 were the primary components, offset by non-cash expenses such as depreciation
and amortization amounting to $1,181,000. During the year, we financed most of our capital expenditures through a new term loan credit facility with Silicon Valley Bank. Other sources and uses of cash in 2002 were not significant.
Of the significant use of cash caused by changes in our working capital accounts, accounts receivable increased $1,678,000, substantially all of which has been collected, as a result of the timing of product sales in December 2002 and the accrual of contractual minimum royalties due from Applied Biosystems at December 31, 2002. Inventories increased $304,000 as the result of our decision to have higher levels of finished chemical intermediates inventory on hand to meet the needs of our customers. Increases in accounts payable and accrued liabilities are the result of normal business fluctuations of a growing company. Deferred revenue, representing up front licensing payments subject to recognition over the terms of the underlying agreements and prepayments for royalties and product purchases, also impacts cash flows from operations. Deferred revenue decreased during 2002, thereby increasing our cash used in operations, due to normal amortizations and the offset of royalty and product prepayments by our customers, reduced by the receipt of a portion of the technology access fee from QIAGEN as part of our license and distribution agreement.
Cash used in investing activities decreased to $881,000 in 2002 compared to $2,963,000 in 2001 due primarily to lower levels of capital expenditures and license rights payments. Cash provided by financing activities increased to $795,000 in 2002 from $349,000 in 2001 due to proceeds from borrowings from our new credit facility offset by lower proceeds from the exercise of warrants and stock options.
In September 2002, we finalized a term loan facility of up to $2,500,000 to finance manufacturing equipment and other assets and a working capital line of credit of up to $750,000 from a commercial bank. Funds may be drawn on the equipment facility at any time through June 30, 2003, and on the working capital line of credit at any time through August 2004. Advances under the term loan and working capital line of credit are secured by a first position security interest in our assets excluding intellectual property. Amounts advanced under term loans are repayable in 36 monthly payments of principal and interest at the bank’s prime rate plus 0.5%. On the working capital line of credit, interest is payable monthly on any unpaid balances at the bank’s prime rate plus 0.5%, with principal payable in full in September 2004. As of December 31, 2002, we have $1,653,000 of available financing under the term loan and $750,000 available from the working capital line of credit.
In 2001, cash used in operations amounted to $2,019,000. Our net loss of $4,576,000 was offset by non-cash depreciation and amortization charges of $1,218,000, and by an increase in deferred revenue caused by receipt of new license fees and advance payments from customers of $1,268,000. Cash used in investing activities was $2,963,000 in 2001, consisting of the license rights of $1,000,000, $1,605,000 in facilities and equipment, including $1,013,000 of December 2000 purchases, and $358,000 of costs associated with the Synthetic Genetics acquisition. The increase in accounts receivable balances from 2000 to 2001 is the result of increased product sales in 2001. The reduction in accounts payable in 2001 is primarily the result of the payout of $1,013,000 in the equipment and leasehold improvements related to the Synthetic Genetics acquisition in late 2000. Accrued liabilities increased in 2001 over 2000 primarily as a result of payroll and employee benefit costs, the majority of which were paid in January and February 2002.
At December 31, 2002, our largest cash commitments are non-cancelable operating leases for facilities in the amount of $7,360,000 that expire in 2012. In addition, we have commitments to supply products to customers in the amount of $772,000 which have been paid for in advance.
Capital expenditures were significantly lower in 2002 than 2001 levels, however further investments in capital expenditures may be necessary to facilitate our anticipated growth in operations. We may also require a larger inventory of raw materials and products to provide better service to our customers. Any such increases, net of any amounts drawn against available credit facilities, can be expected to reduce cash and cash equivalents.
We currently anticipate that existing cash balances, projected cash from operations and unused borrowing capacity under existing bank loans will be sufficient to meet our anticipated working capital and capital expenditures through at least 2003. Our future capital requirements depend on numerous factors, including but not limited to:
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magnitude of our future losses;
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timing and terms of new technology licensing agreements or other strategic relationships that may provide up front license fees or other payments;
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resources that we devote to research and development and sales and marketing in support of our business strategy; and
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capital expenditures necessary to expand manufacturing capacity.
It is possible that we may need to raise additional capital to fund our activities and/or to consummate acquisitions of other businesses, products or technologies. We may be able to raise such funds by selling more stock to the public or to selected investors, or by borrowing money. In addition, even though we may not need additional funds, we may still elect to sell additional equity securities or obtain credit facilities for other reasons. We may not be able to obtain additional funds on terms that would be favorable to our shareholders and us, or at all. If we raise additional funds by issuing additional equity or convertible debt securities, the ownership percentages of existing shareholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock.
Aggregate Contractual Obligations
In addition to the debt obligations reflected on our balance sheet, we have commitments associated with operating leases. The following is a summary of these cash obligations and commitments as of December 31, 2002.
Scheduled payments under contractual obligations (in thousands):
Recent Accounting Pronouncements
In July 2001, the FASB issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 142 requires that goodwill and
intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142.
Epoch adopted the provisions of Statement 141 immediately and Statement 142 effective January 1, 2002. As of the date of adoption, Epoch had unamortized goodwill in the amount of $2,152,000 and unamortized identifiable intangible assets in the amount of $2,263,000 all of which were subject to the transition provisions of Statements 141 and 142. Amortization expense related to goodwill was $15,000 for the year ended December 31, 2000 and $155,000 for the year ended December 31, 2001.
In November 2002, the Financial Accounting Standards Board Emerging Issues Task Force issued its consensus concerning Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 addresses how to determine whether a revenue arrangement involving multiple deliverables should be divided into separate units of accounting, and, if separation is appropriate, how the arrangement consideration should be measured and allocated to the identified accounting units. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not anticipate that adoption of EITF 00-21 will have a material impact on our consolidated financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This Interpretation clarifies the requirements for guarantor’s disclosures in its interim and annual financial statements about its obligations under certain guarantees that it has issued and which remain outstanding. The Interpretation also clarifies the requirements related to the recognition of a liability for the fair value of an obligation undertaken by the guarantor at the inception of the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The disclosure requirements are currently effective, while the recognition and initial measurement provisions will apply to guarantees issued or modified after December 31, 2002. We do not believe that these provisions will have a material impact on our financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. For public enterprises, such as the Company, with a variable interest in a variable interest entity created before February 1, 2003, the Interpretation is applied to the enterprise no later than the end of the first annual reporting period beginning after June 15, 2003. The application of this Interpretation is not expected to have a material effect on the Company’s financial statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the Interpretation becomes effective.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Our financial instruments include cash and short-term investment grade debt securities. We also have term loans on capital equipment through a commercial bank. At December 31, 2001 and 2002 the carrying values of our financial instruments approximated their fair values based on current market prices and rates. We do not believe that fluctuations in interest rates would have a material impact on us. It is
our policy not to enter into derivative financial instruments. We do not currently have material foreign currency exposure as our international transactions are minimal and the majority of our international transactions are denominated in U.S. currency. Accordingly, we do not have significant exposure to foreign currency exchange rate risk at December 31, 2002. In the future, under the terms of the QIAGEN agreement, we will be conducting some of our business in Euros for QIAGEN sales in Europe and in Yen for QIAGEN sales in Japan. We do not anticipate that these transactions will create significant exposure to foreign currency exchange rate risk.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
The financial statements required by this item begin on Page of this Report.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
PART III
ITEM 10.
ITEM 10. Directors and Executive Officers of Epoch.
The information required hereunder is incorporated by reference from the information contained in the sections entitled “Directors,” “Other Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive Proxy Statement for its 2003 Annual Meeting of the Stockholders to be held on May 22, 2003 to be filed with the Securities and Exchange Commission.
ITEM 11.
ITEM 11. Executive Compensation
The information required hereunder is incorporated by reference from the information contained in the sections entitled “Compensation of Executive Officers,” “Option Matters,” “Employment and Severance Agreements” and “Directors Fees” in the Company’s definitive Proxy Statement for its 2003 Annual Meeting of the Stockholders to be held on May 22, 2003 to be filed with the Securities and Exchange Commission.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Matters
The information required hereunder is incorporated by reference from the information contained in the section entitled “Security Ownership of Certain Beneficial Owners and Management,” and “Equity Compensation Plan Information” in Epoch’s definitive Proxy Statement for its 2003 Annual Meeting of the Stockholders to be held on May 22, 2003 to be filed with the Securities and Exchange Commission.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions
The information required hereunder is incorporated by reference from the information contained in the section entitled “Certain Relationships and Related Transactions” in Epoch’s definitive Proxy Statement for its 2003 Annual Meeting of the Stockholders to be held on May 22, 2003 to be filed with the Securities and Exchange Commission.
ITEM 14.
ITEM 14. Controls and Procedures Report
Evaluation of disclosure controls and procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s “disclosure controls and procedures” pursuant to Rule 13a-14(c) under the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that as of the date of the evaluation, the Company’s disclosure controls and procedures were adequate to timely alert them of material information relating to the Company required to be included in the Company’s periodic SEC filings.
Changes In Internal Controls
There were no significant changes in the Company’s internal controls, or to the Company’s knowledge, in other factors that could significantly affect the Company’s disclosure controls and procedures subsequent to the date of our most recent evaluation.
PART IV
ITEM 15.
ITEM 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K
Epoch Biosciences, Inc.
Index to Financial Statements and
Financial Statement Schedules
(Item 14(a)(1) and 14(a)(2)
Independent Auditors’ Report
The Board of Directors and Stockholders
Epoch Biosciences, Inc.
We have audited the accompanying balance sheets of Epoch Biosciences, Inc. as of December 31, 2001 and 2002, and the related statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 financial position of Epoch Biosciences, Inc. as of December 31, 2001 and 2002, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company has adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 provides that beginning in January 2002, Goodwill will no longer be amortized. It is now subject to testing for impairment at least annually.
/s/ KPMG LLP
Seattle, Washington
February 3, 2003
Epoch Biosciences, Inc.
Balance Sheets
Assets
See accompanying notes to financial statements.
Epoch Biosciences, Inc.
Statements of Operations
See accompanying notes to financial statements.
Epoch Biosciences, Inc.
Statements of Stockholders' Equity
See accompanying notes to financial statements.
Epoch Biosciences, Inc.
Statements of Cash Flows
See accompanying notes to financial statements.
Epoch Biosciences, Inc.
Notes To Financial Statements
December 31, 2002
(1) Nature of Business and Summary of Significant Accounting Policies
Nature of Business
Epoch Biosciences, Inc. develops technologies and products to help scientists around the world perform genetic research to improve our lives and our environment. Genetic analysis has become a pervasive activity in academic, biopharmaceutical, clinical, agricultural, veterinary and forensic laboratories. Our technologies facilitate rapid, accurate and cost-effective genetic analysis at the scale necessary to generate the massive amounts of genetic information being studied today.
As the human genome and other animal and plant genomes are sequenced, the task of understanding the structure and function of genes lies before us (genomics). Researchers want to know when and why a gene switches on and begins producing its protein (gene expression) and what the gene’s protein does in the body (proteomics). Finally, researchers want to know what people’s genetic similarities and differences mean for their health and susceptibility to disease. For example, single nucleotide polymorphisms, or SNPs, are tiny differences in our DNA that make humans different from one another. SNPs have been linked to good and bad traits, including hereditary and acquired diseases, and to people’s response to medications.
Because of the implications of understanding gene function on human health and disease, institutions have moved quickly to design and manufacture automated genetic analysis systems. We develop patented technologies that improve the output of these systems and that are compatible with many of the genetic analysis systems currently in use or in development.
Our technologies are useful in genetic research, diagnostics, drug development, infectious disease detection, prenatal testing, and population screening to assess our risk of disease or to predict our response to drugs. Epoch’s products also have application in forensics, food testing, and environmental testing, including bio-warfare and bioterrorism.
We currently anticipate that existing cash balances, projected cash from operations and unused borrowing capacity under existing bank loans will be sufficient to meet our anticipated working capital and capital expenditures through at least 2003. It is possible that we may need to raise additional capital to fund our activities and/or to consummate acquisitions of other businesses, products or technologies. We may be able to raise such funds by selling more stock to the public or to selected investors, or by borrowing money. In addition, even though we may not need additional funds, we may still elect to sell additional equity securities or obtain credit facilities for other reasons. We may not be able to obtain additional funds on terms that would be favorable to our shareholders and us, or at all.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash Equivalents
All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents. Cash equivalents consist of money market accounts and treasury bills.
Financial Instruments and Concentrations of Credit Risk
The Company’s financial instruments consist of cash, cash equivalents, accounts receivable, accounts payable and accrued liabilities and equipment loans from a commercial bank. The fair value of these instruments approximates their financial statement carrying amounts due to their short maturities or floating interest rates.
Credit is extended based on an evaluation of a customer’s financial condition and collateral is generally not required. The majority of revenues are derived from private and public companies and public enterprises in the research market in the United States.
The table below summarizes the revenue and accounts receivable of our customers where our risk is significantly concentrated.
We have one active grant from the Federal Government which was awarded in 2001. We recognized $114,000 and $380,000 in grant revenue in 2001, and 2002, respectively. As of December 31, 2002, we had one open grant with approximately $234,000 remaining to be earned.
Inventory
Inventories are stated at the lower of cost, measured by the first-in and first-out method, or market value, as follows:.
Property and Equipment
Property and equipment are stated at cost. Depreciation of equipment is provided on the straight-line method over the assets’ estimated useful lives, generally three to five years. Amortization of leasehold improvements and capital leases is provided on the straight-line method over the lesser of the estimated useful life or the term of the lease.
Intangible Assets
Intangible assets are stated at cost. Amortization of intangible assets is provided on the straight-line method over the life of the asset. The non-compete agreement has a term of five years. License rights are tied to the expiration date of the underlying patent which generally results in a life of 15 to 17 years.
The excess of the aggregate purchase price over the fair value of the net tangible and specifically identifiable intangible assets of businesses acquired in purchase transactions is recorded as goodwill. Through December 31, 2001, goodwill was amortized over 15 years using the straight-line method. Business acquisition costs allocated to covenants not to compete are amortized over the terms of the agreement, five years, using the straight-line method.
In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill and other indefinite-lived intangible assets, including any such intangibles recorded in past business combinations, are no longer amortized beginning January 1, 2002. SFAS No. 142 specifies that no amortization is recorded for goodwill and other indefinite-lived intangible assets resulting from business combinations completed during the last six months of 2001. SFAS No. 142 also requires the assets to be written down with a goodwill impairment charge against current earnings whenever the recorded values exceed their fair values. If this standard had been implemented as of January 1, 2000, amortization expense would have been reduced by $14,704 in 2000 which would have had no impact on earnings per share, and amortization expense would have been reduced by $154,797 in 2001, and earnings per share would have been increased by $0.01.
Impairment of Long-Lived Assets
For long-lived assets, including property and equipment and intangible assets other than goodwill, we evaluate the carrying value of the assets by comparing the estimated undiscounted future cash flows generated from the use of the assets and their eventual disposition with the assets’ reported net book value. If assets are impaired, we write them down to their fair market values. The carrying value of assets are evaluated for impairment when events or changes in circumstances occur which may indicate the carrying amount of the asset may not be recoverable.
Restricted Cash
Restricted cash represents long-term certificates of deposit pledged under a security agreement, in lieu of a cash deposit, on a facility subject to an operating lease.
Revenue Recognition
We earn revenues from product sales of chemical products and reagents to manufacturers for incorporation into their products, from the sale of specialty oligonucleotides to distributors and end users in the research fields of genomics and molecular diagnostics, from license fees for the use of our proprietary technology and know-how, and by providing services to third parties for performing research and development on their behalf. We also have product royalty agreements that result in royalties to us upon ultimate sales of products by our partners.
Revenues from product sales to customers and distributors that require no ongoing obligations are recognized when shipped to the customer and title has passed.
License fees are recognized over the term of the agreement to which the license fees correspond, which may extend to the expiration of the underlying patents, and based on the terms and future performance obligations in the underlying agreements.
Deferred revenue principally represents license fees received in advance and prepayments for product purchases.
Contract research revenues are recognized as the research and development activities are performed under the terms of commercial collaboration and supply agreements and government grants. Direct costs related to these contracts and grants are reported as research and development expenses.
Royalty revenues are recognized when earned under the terms of the related agreements, which is generally upon sale by our partner of products containing our component products.
Income Taxes
Deferred income taxes are provided based on the estimated future tax effects of carryforwards and temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those carryforwards and temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. A valuation allowance is recorded for deferred tax assets when it is more likely than not that such deferred tax assets will not be realized.
Research and Development Costs
Research and development costs are expensed as incurred.
Stock-Based Compensation
Epoch applies APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations in measuring compensation costs for its employee stock option plans. We disclose proforma net loss and net loss per share as if compensation cost had been determined consistent with Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation. Stock options and warrants issued to non-employees are accounted for using the fair value method prescribed by SFAS 123 and Emerging Issues Task Force 96-18.
Had we determined compensation cost based on the fair value of our stock options on the grant date under SFAS 123, our net loss and net loss per share would have been the pro forma amounts indicated below:
The per share weighted-average fair value of stock options granted during 2000, 2001 and 2002, was $8.02, $4.25 and $1.67, respectively, on the grant date using the Black-Scholes option pricing model with the following assumptions:
Net Loss Per Share
Basic loss per share is computed based on weighted average shares outstanding during the reporting period and excludes any potential dilution. Diluted per share amounts reflect potential dilution from the exercise or conversion of securities into common stock or from other contracts to issue common stock. Our capital structure includes common stock options and common stock warrants, all of which have been excluded from net loss per share calculations as they are antidilutive, as follows:
Reclassifications
Certain 2000 and 2001 balances have been reclassified to conform to the 2002 presentation.
Recent Accounting Pronouncements.
In November 2002, the Financial Accounting Standards Board Emerging Issues Task Force issued its consensus concerning Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 addresses how to determine whether a revenue arrangement involving multiple deliverables should be divided into separate units of accounting, and, if separation is appropriate, how the arrangement consideration should be measured and allocated to the identified accounting units. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not anticipate that adoption of EITF 00-21 will have a material impact on our consolidated financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This Interpretation clarifies the requirements for guarantor’s disclosures in its interim and annual financial statements about its obligations under certain guarantees that it has issued and which remain outstanding. The Interpretation also clarifies the requirements related to the recognition of a liability for the fair value of an obligation undertaken by the guarantor at the inception of the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The disclosure requirements are currently effective, while the recognition and initial measurement provisions will apply to guarantees issued or modified after December 31, 2002. We do not believe that these provisions will have a material impact on our financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. For public enterprises, such as the Company, with a variable interest in a variable interest entity created before February 1, 2003, the Interpretation is applied to the enterprise no later than the end of the first annual reporting period beginning after June 15, 2003. The application of this Interpretation is not expected to have a material effect on the Company’s financial statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the Interpretation becomes effective. We do not believe we have any variable interest entities at this time.
(2) Synthetic Genetics Acquisition
The Company acquired some of the assets and liabilities of Synthetic Genetics, a provider of specialty oligonucleotides in San Diego California, on November 15, 2000 in a transaction accounted for as a purchase business combination. Accordingly, the assets and liabilities of Synthetic Genetics recorded at their estimated fair values at the acquisition date, and the results of Synthetic Genetics operations included in the Company’s results from the acquisition date. The purchase consideration consisted of the following:
Goodwill represents the excess of the purchase consideration over the fair value of identifiable tangible and intangible assets acquired and liabilities assumed, and was being amortized over 15 years. In compliance with SFAS No. 142, effective January 1, 2002, we no longer amortize goodwill, see note (1). Amounts allocated to the non-compete agreement are being amortized over its term of 5 years.
Direct acquisition costs incurred in the Synthetic Genetics acquisition include $250,000 cash paid to Bay City Capital for investment banking services. Bay City Capital, a merchant banking partnership that was formed by The Craves Group and The Pritzker Family business interests, has a 14% equity interest in Epoch at December 31, 2002. The Chairman of Epoch’s Board of Directors, Fred Craves, Ph.D., is a founding partner of The Craves Group, and is the Chairman and a Manager of Bay City Capital, LLC. Sanford S. Zweifach, a member of Epoch’s Board of Directors, was a Managing Director and Chief Financial Officer of Bay City Capital, LLC., at the time of the transaction.
The following unaudited summary, prepared on a pro forma basis presents the combined results of operations as if the acquisition had been consummated as of January 1, 2000, after including the impact of certain adjustments such as depreciation and amortization on assets acquired.
(3) Property and Equipment
Property and equipment consists of the following as of December 31:
Assets under capital leases, included above:
(4) Identifiable Intangible Assets
Identifiable intangible assets consist of the following as of December 31:
Scheduled amortization charges from identifiable intangible assets as of December 31, 2002 are as follows:
(5) Long-Term Obligations
Long-term obligations consist of the following as of December 31:
A loan agreement with a commercial bank provides for term loans of up to $2,500,000 to finance manufacturing equipment and other assets and a working capital line of credit of up to $750,000. Funds may be drawn on the equipment facility at any time through June 30, 2003, and on the working capital line of credit at any time through August 2004, provided that we are in compliance with the following financial covenants:
• Adjusted Quick Ratio of 1.3:1. Adjusted Quick Ratio is defined as the sum of unrestricted cash and cash equivalents and trade accounts receivable divided by the sum of current liabilities, excluding current deferred revenues, and bank debt.
• Minimum Tangible Net Worth of $1,500,000. Minimum Tangible Net Worth is defined as total equity in accordance with generally accepted accounting principles less intangible assets.
We are currently in compliance with each of these covenants. Advances under term loans and the working capital line of credit are secured by a first position security interest in our assets excluding intellectual property. Amounts advanced under term loans are repayable in 36 monthly payments of principal and interest at the bank’s prime rate plus 0.5%. On the working capital line of credit, interest is payable monthly on any unpaid balances at the bank’s prime rate plus 0.5%, with principal payable in full in September 2004. The bank’s prime rate on March 11, 2003 was 4.25%. As of December 31, 2002, we have drawn $847,352 against the term loan. No amounts were drawn on the working capital line of credit.
The aggregate amount of long-term obligations at December 31, 2002 maturing by calendar year is as follows:
(6) Accrued Liabilities
Accrued liabilities consist of the following as of December 31:
(7) Retirement Savings Plan
Epoch has a profit sharing plan which is qualified under Section 401(k) of the United States Internal Revenue Code. The plan allows eligible employees to contribute up to 20% of their salary. The Company, at its discretion, makes matching contributions to the plan. No matching contributions were made to the plan in 2000, 2001 or 2002.
(8) Equity
Options to Purchase Common Stock
Epoch has two stock option plans (“Stock Option Plans”) pursuant to which an aggregate of 3,660,068 shares of common stock have been reserved for grants. The Stock Option Plans provide for incentive stock options and non-qualified options to be granted to employees, directors, and other non-employee individuals responsible for the management, growth, and financial success of the Company. The option price is determined by the Board of Directors at the time the option is granted, and, in the case of incentive options, must be at least equal to the fair market value of the common stock at the time of the grant. Options granted to employees generally vest over a 4-year period of continuous employment while options granted to non-employee members of the Board of Directors vest over one year.
A summary of the stock option plans follows.
The following table summarizes information about stock options at December 31, 2002:
Warrants to Purchase Common Stock
In February 2000, Epoch exercised the redemption provision on certain warrants, representing 3,801,812 shares of common stock. Warrants representing 3,798,762 shares of common stock were exercised generating $9,497,000 in cash. In addition to the warrant redemption, 218,249 other warrants were exercised in 2000 generating $109,030 in cash.
In May 2000, we issued three year fully vested warrants to purchase 25,000 shares of our common stock for public relations services. The warrants have strike prices of $8.00 for 5,000 shares, $10.00 for 5,000 shares, $12.00 for 5,000 shares, $14.00 for 5,000 shares, and $16.00 for 5,000 shares. This warrant was valued using the Black Scholes option pricing model.
In September 2000, we issued five year fully vested warrants to purchase 25,000 shares of common stock at $7.00 per share for consulting services related to the private placement and warrant call. This warrant was valued using the Black Scholes option pricing model.
In November 2000, we issued five year fully vested warrants to purchase 40,000 shares of common stock at $10.19 per share to a Bay City Capital entity managed by Bay City Capital, LLC in lieu of cash fees for investment banking and consulting services. Bay City Capital, a merchant banking partnership that was formed by The Craves Group and The Pritzker Family business interests, has a 14% equity interest in Epoch at December 31, 2002. The Chairman of Epoch’s Board of Directors, Fred Craves, Ph.D., is a founding partner of The Craves Group, and is the Chairman and Managing Director of Bay City Capital, LLC. Sanford S. Zweifach, a member of Epoch’s Board of Directors was a Managing Director and Chief Financial Officer of Bay City Capital, LLC at the time of the transaction. This warrant was valued using the Black Scholes option pricing model.
In December 2000, we issued a five-year warrant to purchase 10,000 shares of common stock at $6.69 per share to a consultant to the company. The shares vest monthly over four years. This warrant is variable and is being valued using the Black Scholes option pricing model.
In January 2002, we issued a five year warrant to purchase 15,000 shares of common stock at $2.53 per share for investor relations services. The shares vested in equal monthly installments over one year. The warrant was valued using the Black Scholes option pricing model.
A summary of our outstanding warrants follows.
Our warrants have expiration dates that range to 2007 and all warrants are fully vested at December 31, 2002 with the exception of 4,624 warrants issued to consultants that vest monthly through 2004. Non-cash expenses resulting from the issuance of warrants was $761,974 in 2000, $8,859 in 2001, and $38,084 in 2002.
(9) Income Taxes
There was no income tax benefit recognized for our net losses in 2000, 2001, and 2002. The difference between taxes computed by applying the U.S. Federal corporate tax rate of 34% and the actual income tax provision in 2000, 2001 and 2002 is primarily the result of limitations on utilizing net operating losses.
The tax effects of temporary differences and carryforwards that give rise to significant portions of the deferred tax assets at December 31, 2001 and 2002 are presented below:
The net change in the valuation allowance for 2000, 2001, and 2002 was an increase of approximately $1,805,000, $1,898,000, and $1,299,000, respectively, due primarily to doubt as to our ability to utilize net operating losses and research and development credits.
At December 31, 2002, we had net operating loss carryforwards for income tax purposes of approximately $47,755,000 and unused research and development tax credits of approximately $2,328,000 available to offset future taxable income and income taxes, respectively, expiring through 2020. Our ability to utilize net operating loss and credit carryforwards is limited pursuant to the Tax Reform Act of 1986, due to cumulative changes in stock ownership in excess of 50%.
(10) Leases
In February of 2000, we entered into a 12-year non-cancelable operating lease for 25,000 square feet of office and laboratory space in Bothell, Washington, which we occupied in November 2000. We also lease office and manufacturing space in San Diego under an operating lease that expires in November 2005. This lease can be terminated upon 90 days written notice.
Future minimum cash payments under non-cancelable operating leases are as follows:
Rent expense is recognized on the straight-line method over the term of the leases. Rent expense on operating leases was $377,153 in 2000, $793,019 in 2001, and $781,667 in 2002.
(11) Legal Proceedings
Mordecai Jofen, as Trustee of the Harbor Trust, f/k/a The Edward Blech Trust v. Epoch Biosciences, Inc., United States District Court for the Southern District of New York, Case No. 01 CV 4129
The Harbor Trust (formerly the Edward Blech Trust) filed a complaint against us, alleging the breach of a 1996 letter agreement between us and David Blech. Pursuant to the letter agreement, upon payment of a pre-existing debt owed to us by Blech (the “Ribonetics Debt”), we were to release to Blech from escrow warrants to purchase 500,000 shares of our stock. Blech assigned all of his rights under the letter agreement to the Harbor Trust. The Harbor Trust’s claim is based on our alleged failure to timely register the common stock underlying the warrants, allegedly resulting in damages to Blech and/or the Trust of at least $10 million, based on the peak trading value of our stock.
We filed a motion to dismiss the complaint based on, among other things, the positions that: (1) Blech and the Harbor Trust have never had rights to receive or exercise the warrants because Blech failed to perform a condition precedent, i.e., payment of the Ribonetics Debt; and (2) we had no obligation to register the stock unless and until Blech was entitled to the warrants. Further, the warrants expired pursuant to the letter agreement in June 2000. The Court granted our motion to dismiss in November 2001, but gave the Harbor Trust leave to file an amended complaint, which they filed in December 2001. We filed a motion to dismiss the amended complaint in January 2002. In July 2002, the Court decided in our favor and granted the motion to dismiss without leave to file an amended complaint.
In August 2002 the Harbor Trust appealed the Court’s dismissal of its case to the United States Court of Appeal for the Second Circuit. The appeal is likely to be resolved in the second quarter of 2003. While we believe we have a strong position, it is not possible at this time to state the likelihood of an unfavorable outcome because of the inherent uncertainties of litigation.
(12) Selected Quarterly Financial Data (unaudited)
Summary unaudited quarterly financial data for 2001 and 2002 is as follows:
Power Of Attorney
Each person whose signature appears below hereby authorizes Bert W. Hogue and/or William G. Gerber, as attorney-in-fact, to sign in his behalf and in each capacity stated below, and to file, all amendments and/or supplements to this Annual Report on Form 10-K.
Signatures
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 26, 2003
EPOCH BIOSCIENCES, INC.
(Registrant)
By:
/s/ Bert W. Hogue Bert W. Hogue
Vice President, Secretary, and Chief Financial Officer
In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons of the registrant in the capacities and on the dates indicated.
/s/ Herbert L. Heyneker
Herbert L. Heyneker, Ph.D.
Director
March 21, 2003
/s/ Michael Ybarra Lucero
Michael Ybarra Lucero
Director
March 25, 2003
/s/ Riccardo Pigliucci
Riccardo Pigliucci
Director
March 21, 2003
/s/ Bert W. Hogue
Bert Hogue
Vice President, Secretary and Chief Financial Officer
(Principal Financial and Accounting Officer)
March 26, 2003
Certifications
I, William G. Gerber, President and Chief Executive Officer of Epoch Biosciences, Inc. (the “Company”), certify that:
1.
I have reviewed this Annual Report on Form 10-K of the Company;
2.
Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3.
Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4.
The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14 of the Exchange Act) for the registrant and we have:
a)
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c)
presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a)
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 26, 2003
By:
/s/ William G. Gerber William G. Gerber
President and Chief Executive Officer
I, Bert W. Hogue, Chief Financial Officer of Epoch Biosciences, Inc. (the “Company”), certify that:
1.
I have reviewed this Annual Report on Form 10-K of the Company;
2.
Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3.
Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4.
The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14 of the Exchange Act) for the registrant and we have:
a)
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c)
presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a)
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 26, 2003
By:
/s/ Bert W. Hogue Bert W. Hogue
Vice President and Chief Financial Officer
EXHIBIT INDEX