ITEM 1 BUSINESS
General
We provide specialty laboratory services to support pharmaceutical, biotechnology and laboratory diagnostic manufacturers in the conduct of human clinical research, for use in their drug and diagnostic product development efforts. Our clients include a number of the world’s largest multi-national pharmaceutical, biotechnology and diagnostic companies. Our well-recognized specialty areas include
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Diabetes
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Obesity
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Cardiovascular diseases (dyslipidemia, atherosclerosis, and coronary heart disease),
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Rheumatology and Bone diseases, (including osteoporosis, osteoarthritis and rheumatoid arthritis.
Coupled with our specialty testing, we also have central laboratory capability and provide full-service central laboratory support for multi-center clinical trials, including routine safety lab tests. We participate in all in-human clinical trials, phases I - IV.
We also perform clinical biomarker services for novel biomarkers, as well as custom assay services for our pharmaceutical and biotechnology clients. Through our biomarker services, we provide assay development services for novel biomarkers, as well as custom assay services for immunogenicity testing and multiplex testing. We anticipate that our clinical biomarker services will help diversify our client base because these services apply to therapeutic areas beyond our traditional specialty areas. We believe that the growing number of biological and biosimilar drugs under development will drive increasing demand for highly specialized and technical consultative services. We expect that these biomarker services will also complement and extend our strong reputation in this specialty testing sector.
Our company is a Delaware corporation, incorporated in May 1996, and we conduct our operations primarily through our wholly-owned subsidiary, Pacific Biomarkers, Inc., a Washington corporation.
Business Strategy
Our primary business strategy is to increase our revenues and market share by providing high quality specialty reference laboratory services in our core areas, and growing our novel biomarker services, a dynamic sector of laboratory services for clinical drug development.
A key component of our strategy is to meet the outsourcing needs of pharmaceutical, biotechnology, diagnostic companies and other central laboratories. Specialty reference and central laboratory service companies like ours typically derive substantially all of their revenue from the research and development expenditures of the pharmaceutical, biotechnology, and diagnostic industries. Participants in these industries typically outsource a significant quantity of these services both to central laboratories and to specialty reference laboratories. We believe that such outsourcing will continue and may increase in the future because of many factors, including continuing pressures on the pharmaceutical and biotechnology industries to contain costs, limitations on pharmaceutical companies’ internal capacity, difficulty in developing expertise in specialty testing areas internally within pharmaceutical companies or central labs, a need for faster development time for new drugs, research in multiple countries simultaneously and stringent government regulation. In addition, central laboratories outsource to specialty reference laboratories some of the testing that requires specialized expertise. Referrals from large clinical laboratories depend on whether the central laboratory has internal expertise and their internal work capacity, and ongoing consolidation in the industry has affected the level of referrals.
Another component of our strategy is to assist in enhancing the drug and diagnostic development processes by developing and delivering innovative services that apply science and technology in the provision of high quality service within our areas of specialty. The development of new drugs and diagnostic products require a significant investment of time and money by pharmaceutical, biotechnology, and diagnostic companies. We believe that these factors create opportunities for companies like ours to provide our expertise and services to help reduce the time in the drug development and laboratory diagnostic product development processes and make the processes more efficient.
Described below are other efforts we are pursuing, or may pursue in the future, to further our business strategies.
Increase Specialty Areas
Our goal is to expand our specialty laboratory expertise, beyond our core specialties of cardiovascular diseases and rheumatology and bone diseases, within related areas where we have a competitive advantage of existing in-depth expertise. This includes novel biomarkers, immunogenicity, central nervous system disorders and multiplexing platforms.
As part of this strategy, in fiscal 2008, we expanded our service offerings into new areas, both in terms of therapeutic areas and assay methodologies. Through our biomarker services, we offer custom biomarker assay development, immunogenicity assay development, and multiplex testing. We expect these activities to lead to significant growth in our customer base and increases in our future revenues.
In fiscal year 2010 we began working on a biomarker initiative with the aim of identifying a set of biomarkers that current literature and experimental evidence indicate have the greatest possibility of being used in the early identification and treatment of (drug)-induced Acute Kidney Injury (AKI). Drug-induced organ injury is a serious condition accounting for as much as $75 billion for every 250 compounds tested. We believe that the pharmaceutical companies have a major business incentive for early detection of flawed drugs. Development costs for each approved drug cost approximately $1 billion or more to develop over an average timeframe of 10 years. Assuming an average of 250 compounds tested yearly and 30% found toxic, 75 compounds would be spared full development resulting in savings of up to $7.5 billion per year. This ongoing initiative is designed to help the pharmaceutical companies by reliably measuring biomarkers that prevent compounds from entering the next stage of development unless they are free of drug-induced toxicity. We have already validated a majority of biomarkers associated with kidney organ injury specified by the Predictive Safety Testing Consortium (PSTC). During fiscal year 2011 we plan to validate other organ injury biomarkers utilizing the standards established by the PSTC.
Diversify Client Base
We have a goal to continue to diversify our client base, both in terms of the number of clients and the number of contracts within any particular client.
As a result of ongoing business development and client diversification efforts, we added 12 new clients to our client base during the fiscal year ended June 30, 2010, and 9 new clients in fiscal 2009, and we continue to diversify the total number and types of study contracts. At June 30, 2010, we held a total of 159 active contracts, compared to 137 active contracts at June 30, 2009, a 16% increase. Management believes that as a result of these continuing business development activities, we will incrementally diversify our client base and spread our revenues across a larger number of clients and a larger number of individual study contracts.
We anticipate that our clinical biomarker services will help diversify our client base. These biomarker services apply to therapeutic areas beyond our traditional specialty areas, and there is also an emphasis on the rapidly growing segment of biologic drugs. As a result, we hope to develop client relationships with new divisions within existing clients, as well as with other companies in the pharmaceutical and biotechnology industries with whom we previously have not contracted. We believe that these biomarker services will complement and extend our strong reputation in specialty testing services.
Acquisitions and Strategic Relationships
Our clients and our competitors have experienced significant consolidation over the last several years and we expect that trend to continue. The uncertainty caused by the consolidation trend may result in other companies in the industry seeking to form strategic relationships or joint ventures or to be acquired in order to stay competitive. This may make it possible for us to make strategic acquisitions that are complementary to our existing services and that expand our ability to serve our clients. We are also exploring other strategic alternatives for our business and operations, which may include joint ventures, co-marketing relationships or other strategic relationships. Additionally, we will evaluate, as appropriate, any potential business combinations involving our company as a whole, or involving a portion of our assets.
Services
We provide specialty reference laboratory services and clinical biomarker services, as well as central laboratory services.
Specialty Reference Laboratory Services
Our specialty reference laboratory in Seattle, Washington has established itself as a technical leader due to our strong expertise in certain core areas. Our three well-recognized specialty areas include:
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cardiovascular diseases (dyslipidemia, atherosclerosis, and coronary heart disease),
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diabetes, metabolic syndrome, and obesity, and
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rheumatology and bone diseases (osteoporosis as well as osteoarthritis and rheumatoid arthritis).
Management believes that among prospective new drugs, these areas of expertise represent three of the top ten areas of focus by the pharmaceutical industry.
With respect to cardiovascular diseases, we are one of the leaders in lipid services for clinical drug development and diagnostic product development in the U.S. and internationally. Our expertise is concentrated on the measurement of cardiovascular disease markers, especially cholesterol and lipoproteins, including HDL, LDL and subfractions thereof, remnant cholesterol, apolipoproteins, Lp(a), and protein and lipid composition of lipoproteins.
We are enhancing our activities in the area of diabetes and related disorders, notably obesity and metabolic syndrome. Moreover, we are expanding our test menu in areas related to diabetes and metabolic syndrome, notably in testing for markers of inflammation and gut hormones. In prior fiscal years, we noticed a significant increase in interest in assays for hormones such as GLP-1, GIP, PYY, and ghrelin, which are produced in the gut and are dysregulated in conditions such as diabetes and obesity. In the fiscal year of 2010 we have added additional novel gut hormones to our test menu as well as improved our current panel of gut hormones. The American Diabetes Association reports in 2010 that diabetes is the fastest growing disease in the history of the United States. Diabetes kills more people than breast cancer and AIDS combined and if current trends continue, one in three children born since 2000 will develop diabetes in their lifetime. Every 19 seconds a new case of diabetes is diagnosed. Diabetes costs the U.S. approximately $218 billion each year. Because of our established strengths in testing for lipids, cardiovascular risk and diabetes, we believe we are well positioned to take advantage of this emerging area of pharmaceutical drug development. We believe our strength in performing these difficult assays will be attractive to our clients and be a significant source of future revenues.
In fiscal year 2010 we developed a novel method for the measurement of bile acids using our LC-MS/MS platform acquired earlier the same year. Bile acids are well recognized as essential for regulating cholesterol homeostasis and the digestion and absorption of fat through the intestine, but in recent years, bile acids have emerged as signaling molecules with endocrine functions, acting as ligands for the G-protein coupled receptor TGR5 and the nuclear receptor farnesoid X receptor (FXR). This has elevated the importance of bile acids beyond fat digestion and into triglyceride, cholesterol, and glucose homeostasis. We believe this assay will support our already ongoing programs in the diabetes and cardiovascular areas because of the growing interest in bile acids as therapeutic targets for the treatment of obesity, type 2 diabetes, and hyperlipidemia.
In the areas of bone metabolism and women’s health, we also specialize in the measurement of hormones, and our menu of biochemical markers includes pyridinolines, various C- and N- terminal telopeptides, procollagens, osteocalcin and bone-specific alkaline phosphatase. Moreover, in recent years we have actively expanded our test menu to include biochemical markers of cartilage turnover as relating to drug development for arthritis, and we have performed specialty testing to support clinical drug development of drugs for rheumatoid arthritis and osteoarthritis. Further, we expect to see renewed increases in demand for our testing services in drug development for rheumatoid arthritis, and we expect this to be a significant source of future revenues.
In connection with these stated areas of expertise, we offer a variety of services through our specialty reference laboratory, including
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clinical study testing services,
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development of laboratory reference methods,
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development of clinical trial protocols, and
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contract research and development.
Our involvement with clients frequently begins at the protocol design stage. Clinical trial support includes coordinating the collection and receipt of specimens from investigative sites, processing the samples, generating test databases and reporting the consolidated data to study sites and sponsors. The extensive knowledge we have in test development and our close collaboration with diagnostic manufacturers, frequently allow us to offer novel tests to our clinical research clients before such tests are commercially available.
We have developed certain computer software and proprietary processes and procedures intended to enhance the quality and effectiveness of our services. These proprietary processes derive from the technical expertise, knowledge, ability and experience of our laboratory professionals, and provide significant benefits to our clients.
Novel Biomarker Services
In fiscal 2008, we began offering new testing services that relate to the use of biomarkers in clinical drug development. “Biomarkers” are any biological parameters that can be measured in patient samples (e.g., blood or urine) and that provide specific information about the effects (both safety and efficacy) of a particular drug. There is a rapidly growing trend in the pharmaceutical and biotechnology industries to use biomarkers to help guide drug development. We have noticed recently more companies that offer various types of biomarker services. We believe that this investment by others in this area validates our conclusion that this is not only a significant growth area, but that we also have an appropriate strategy to win more business in this area.
Leveraging our extensive experience and expertise in performing demanding assays as well as our long history of supporting diagnostic product development, we created our biomarkers division to focus on this new market segment and to aggressively expand and market our services for:
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biomarker assay development
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immunogenicity testing
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multiplex testing
We anticipate that our clinical biomarker services will help diversify our client base because these services apply to therapeutic areas beyond our traditional specialty areas, and there is also an emphasis on biologic drugs. We also expect that these biomarker services will complement and extend our strong reputation in specialty testing services.
Clients / Marketing
We provide specialty reference, novel biomarker and central laboratory services to the pharmaceutical, biotechnology, and laboratory diagnostic industries. The majority of our clients are pharmaceutical companies, many of which are on the list of Fortune 500 companies, and 37% of our revenue was derived from these Fortune 500 clients in fiscal 2010. Our clients generally range from the world’s largest pharmaceutical companies and biotechnology companies to small and start-up organizations. Our clients also include large central laboratories for whom we provide subcontractor services for our specialty reference laboratory testing.
Our revenue has been concentrated in a small number of clients. For revenue calculations we aggregate as a single client all revenues we receive from several operating divisions within one pharmaceutical or biotechnology company. We routinely have two or more large clients who individually account for more than 10% of our revenue. Our two largest clients in fiscal 2010 represented 46% of our revenue (27% and 19%, respectively), as compared to 40% from our two largest clients in fiscal 2009 (27% and 13%, respectively). One of these clients was the same and one was different in each fiscal period. Revenue from our five largest clients represented approximately 65% and 70% of total revenue in fiscal 2010 and 2009. The loss of any of our largest clients could have a material adverse impact on our revenues and results of operations.
Our scientific expertise is an integral and interrelated part of our business development, marketing and sales process. Our success in business development depends in part on our reputation in the industry and client perceptions (particularly as to our scientific expertise, but also our laboratory capacity and financial health), and also to a degree on personal relationships between us and the client. Accordingly, our Chief Scientific Officer and science and technology team are directly involved in sales and marketing through company capability and scientific presentations as well as consultation with pharmaceutical clinical teams beginning at the protocol design stage.
We continually focus on our business development efforts, and we added two employees to our business development group during fiscal 2010, in addition to the work of our science and technology team. The primary component of our business development efforts has been directed towards pharmaceutical and biotechnology companies, which includes our novel biomarkers business, and we expect this to continue. We also constantly seek to build relationships with other large clinical laboratories for referral work for our specialty laboratory testing.
Contractual Arrangements
We enter into contracts with all of our clients for our laboratory services. Contracts may range from a few months to several years depending on the nature of the work performed and the duration of the client’s study. For some contracts, a portion of the contract fee is paid at the time the study or trial is started with the balance of the contract fee payable in installments upon the progress of the work completed or achievement of milestones over the study or trial duration. We recognize revenue in the period that we perform the related services.
We often enter into master service agreements with clients under which we perform services based on work orders submitted to us from time to time by the client. As of the end of our 2010 fiscal year, we had master service agreements with 20 of our clients as compared to 16 agreements we had as of June 30, 2009. There is no guaranteed minimum number of work orders or revenue to us under these master service agreements. Each work order is separately negotiated with the client and is usually limited to a specific project with limited duration.
Our contracts with clients are primarily fixed price, where our fees are based on the number of samples we test at an agreed-upon price per sample. In such cases, we benefit if our costs are lower than we anticipated but we bear the cost of overruns. Occasionally, we may enter into contracts priced as a fee-for-service (with or without a cap). In such cases, the contracts contain an overall budget for the trial based on time and cost estimates. If our costs are lower than anticipated, the client generally benefits from the savings. If our costs are higher than estimated, we bear the responsibility for the overrun unless the increased cost is a result of a change requested by the client, such as an increase in the number of patients to be enrolled or the type or amount of data to be collected. For the 2010 and 2009 fiscal years, fixed price contracts amounted to 100% of our revenue.
Most of our contracts or work orders may be terminated or modified at any time by the client. Clients may terminate, delay, or change the scope of a project for a variety of reasons including unexpected or undesirable clinical results, a decision to forego a particular study, regulatory issues and other factors outside of our control. Our contracts typically entitle us to receive payment for services performed by us up to the time of termination and reimbursement for out-of-pocket costs incurred prior to termination. In certain limited instances, if a study is terminated early our contracts may also entitle us to a termination fee or payment for the costs of winding down the terminated project.
Recently, we have observed that our pharmaceutical and biotechnology clients have been shifting to “adaptive clinical trials”. These adaptive clinical trial protocols are designed to replace large, multi-year, multi-million dollar contracts. After each adaptive clinical trial phase, the pharmaceutical or biotechnology company reviews the results and decides whether to continue or discontinue the work, after which we may be awarded another small contract for another discrete clinical phase. Compared to our traditional contract business, these adaptive clinical trials are shorter in duration and with fewer test samples sent to us, resulting in a smaller dollar value contract.
Competition
The clinical laboratory services industries, including specialty reference, novel biomarker and central laboratory services, have many participants ranging from small, limited-service providers to a limited number of full-service laboratories with global capabilities.
For specialty reference laboratory services in our areas of expertise, we primarily compete against other full-service and limited-service specialty and central laboratory services organizations and, to a lesser extent, laboratories in academic centers. Many of these organizations have significantly greater resources than we do, with somewhat different focus and business targets. In addition, with the increased focus on biomarkers in drug development, we are noticing more companies that offer various types of biomarker services. Our significant competitors in specialty reference and biomarker laboratory services include Covance, PPD, LINCO (Millipore), Quintiles, ICON, Synarc, Medpace, Esoterix (Labcorp), IBT Laboratories, ALTA Immunochemistry, Charles River Laboratories, Tandem Labs, Eurofins, Clearstone Central Laboratories, CRL, Cetero, and Cedra.
There is significant competition for clients on the basis of many factors for both specialty reference and full-service central laboratory services and biomarker services, including
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technological expertise and efficient drug development processes,
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financial stability,
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reputation for on-time quality performance,
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strengths in various geographic markets and global reach,
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ability to manage large-scale clinical trials both domestically and internationally,
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expertise and experience in specific areas,
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scope of service offerings,
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price,
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ability to acquire, process, analyze and report accurate data in a timely manner,
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size, and
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expertise and experience in health economics and outcomes services.
While size and global reach are more important competitive factors in the central laboratory services business, we believe that technological expertise is more important for specialty reference laboratory services. Except as to size and international capacity, where we know certain other competitors have an advantage, we believe we compete very favorably in a majority of these areas, particularly with respect to our technical expertise in our three specialty areas.
Government Regulation
Our laboratory services are subject to various regulatory requirements designed to ensure the quality and integrity of our laboratory testing in support of clinical trials. The industry standards for conducting clinical laboratory testing are embodied in the Clinical Laboratory Improvement Amendments of 1988 (“CLIA”). As a medical test site in the State of Washington and with a clinical laboratory permit in the State of New York, we have established quality assurance programs at our laboratory facilities that monitor ongoing compliance with CLIA. In addition, we are a College of American Pathologists (“CAP”)-certified test site. This certification provides monitoring for CAP and CLIA compliance by CAP on a continual basis.
The industry standards for conducting preclinical laboratory testing are embodied in the Good Laboratory Practices (“GLP”) regulations as defined by the FDA. For the majority of our testing, which is not related to preclinical research, we do comply with specific sections of the GLP regulations, at our discretion, when it is either important to our clients or is determined by management as advantageous to our quality assurance program. Additionally, PBI is now offering fully GLP compliant services as requested by our clients.
Our clinical laboratory services are subject to industry standards for the conduct of clinical research and development of studies that are embodied in the regulations for Good Clinical Practice (“GCP”). The FDA requires that test results submitted to such authorities be based on studies conducted in accordance with GCP. Noncompliance with GCP can result in the disqualification of some or all of the data collected during the clinical trial, as well as precipitate a full investigation of all previous and current regulatory submissions.
We are subject to licensing and regulation under federal, state and local laws relating to workplace hazard communications and employee right-to-know regulations, the handling and disposal of medical specimens and hazardous waste and radioactive materials, as well as the safety and health of laboratory employees. Our laboratory is subject to applicable federal, state and local laws and regulations relating to the storage and disposal of all laboratory specimens including regulations of the Environmental Protection Agency, the Nuclear Regulatory Commission, the Department of Transportation, the National Fire Protection Agency and the Resource Conservation and Recovery Act. Although we believe that we are currently in compliance in all material respects with such federal, state and local laws, failure to comply could subject us to denial of the right to conduct business, fines, criminal penalties and other enforcement actions.
In addition to its comprehensive regulation of safety in the workplace, the Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers whose workers may be exposed to blood borne pathogens such as HIV and the hepatitis B virus, as well as radiation. Our employees receive initial and periodic training focusing on compliance with applicable hazardous materials regulations and health and safety guidelines.
In the past few years, the United States and foreign governments have become more concerned about the disclosure of confidential personal data. In the U.S., the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) governs the disclosure of confidential medical information. We do not process IIHI (Individually Identifiable Health Information) during any phase of our business practices related to clinical testing. We therefore are currently exempt from HIPAA regulations.
The regulations of the U.S. Department of Transportation, the U.S. Public Health Service and the U.S. Postal Service apply to the surface and air transportation of laboratory specimens. We also comply with the International Air Transport Association (IATA) regulations, which govern international shipments of laboratory specimens. Furthermore, when materials are sent to a foreign country, the transportation of such materials becomes subject to the laws, rules and regulations of such foreign country.
Employees
At September 21, 2010, we had 69 full-time employees and 2 temporary or contract employees, for a total of 71 employees, 47 of whom were employed in laboratory operations, laboratory administration and client services, 6 were employed in sales, marketing and business development, and 18 were employed in administrative capacities. Six of our employees hold doctorate level degrees and two others hold master’s degrees or other postgraduate degrees. None of our employees are represented by labor unions. We believe that our relationships with our employees are good.
Available Information
We make available free of charge through links on our website at www.pacbio.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC.
ITEM 1A
ITEM 1A RISK FACTORS
The following discussion in this Annual Report on Form 10-K contains forward-looking statements regarding our company, our business, prospects and results of operations that involve risks and uncertainties. Our actual results could differ materially from the results that may be anticipated by such forward-looking statements and discussed elsewhere in this Report. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below, as well as those discussed under the captions “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as those discussed elsewhere in this Report. In evaluating our business, prospects and results of operations, readers should carefully consider the following factors in addition to other information presented in this Report and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations. See “Cautionary Notice Regarding Forward Looking Statements.”
Risks Relating to Our Company and Our Business
We may bear financial losses because our contracts may be delayed, terminated or reduced in scope for reasons beyond our control.
Our contracts may be terminated, delayed or reduced in scope by our clients at any time, either immediately or upon notice. See “BUSINESS - Contractual Arrangements” above. Contract termination, delay or reduction in scope may occur for a variety of reasons, most of which are beyond our control, including:
· unexpected or undesired clinical results;
· insufficient patient enrollment by the client;
· insufficient investigator recruitment by the client;
· client budgetary constraints;
· the client’s decision to terminate the development of a product or to end a particular study.
Because we primarily receive revenue on the basis of the number of clinical samples we test and process, the loss, reduction in scope or delay of a large contract or the loss or delay of multiple contracts could materially adversely affect our business, results of operations, financial condition and cash flows. Our contracts typically entitle us to receive payment for fees earned by us up to the time of termination and reimbursement for out-of-pocket costs incurred prior to termination. However, most of our contracts do not entitle us to a termination fee or payment for the costs of winding down the terminated projects.
We depend on small number of clients for a significant portion of our revenue. Any decrease in revenue from these clients could materially adversely affect us.
Our revenue has been concentrated in a small number of clients. We can be materially adversely impacted by decreases in work generated from these clients, including delays in undertaking clinical studies or submitting samples for testing services, early termination or reductions in work orders or clinical studies, or decreases in the volume or timing of new work orders. See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and see “BUSINESS - Clients/Marketing” above.
We have expanded our business development efforts and have continued to submit bids and proposals to these and other companies for our services, to increase our revenue and to diversify our client base. Although we believe that we have good relations with all of our large clients and other companies in the industry, and we expect to receive additional work orders in the future, we cannot predict the timing or amount of any such additional work or whether we will be successful in further diversifying our client base. If we are unsuccessful in our sales and business development efforts with our existing clients and potential clients, our backlog and our revenue will be adversely affected. In addition, unless we are able to attract additional clients for medium to large studies, we will continue to be dependent on a small number of clients for a substantial majority of our revenue.
If we do not gain new clients and new projects from our business development efforts, our growth may be limited, sales of our services may decrease and our operating results may suffer.
We generally do not have long-term contracts with clients for our services. The client may terminate projects that we undertake at any time. As a result, it is difficult for us to forecast future sales, and our future revenue depends on our ability to generate new clients and new projects. Our business development efforts are substantially dependent on our ability to effectively manage our time, personnel and resources. In particular, our Chief Scientific Officer and other scientists are often heavily involved in the marketing and business development process, and time that they spend in this area detracts from their available time for laboratory and development work. Our success in business development depends in part on our reputation in the industry and client perceptions (including as to our laboratory capacity and financial health), and also to a degree on personal relationships between the client and us. With the significant consolidation in the pharmaceutical industry, it is often a long and complex process in finding and meeting with the right person within the client company. We also understand that some companies in the pharmaceutical industry have “preferred vendor lists, such that a vendor cannot participate in requests for proposal or contract with the company unless the vendor is pre-approved on the list. We are hopeful that with the expansion of our existing service offerings and novel biomarker services, we will be able to attract new clients. If our business development efforts are not successful, our revenue and cash flow may decrease and our operating results may suffer.
We may bear financial risk if we under price our contracts or overrun cost estimates.
Since our contracts are primarily often structured as fixed price (or to a lesser extent as fee-for-service with a cap), we bear the financial risk if we initially under price our contracts or otherwise overrun our cost estimates. Such under pricing or significant cost overruns could have a material adverse effect on our business, results of operations, financial condition and cash flows.
Our contract backlog may not result in future revenue.
For internal management purposes, we maintain a contract backlog to track our signed contracts and the anticipated revenues that may be earned in the future for work that has not yet been performed under those signed contracts. Management uses backlog as a financial metric to internally track our business development efforts and anticipated revenues. The scope of the projects and studies we perform under our signed contracts varies significantly, from a few months to over several years; however, those studies or contracts can be terminated, revised, or delayed at any time. As a result, although backlog can provide helpful information to our management, we believe that our aggregate backlog as of any date is not necessarily a reliable indicator of our future results. Our backlog is also affected by the size and duration of our contracts, and as we see more clients moving towards adaptive clinical trials, resulting in smaller contracts with shorter duration, this will impact our backlog and reduce our visibility of forward revenues. A reduction in backlog during any particular period or the failure of our backlog to result in future revenues could adversely affect our results of operations.
Our revenue is unpredictable and varies significantly from quarter to quarter and year to year.
We typically experience significant quarterly fluctuations in revenue in any fiscal year. Our revenue depends in large part on receiving new clinical or diagnostic studies and biomarker development projects from our clients. We cannot predict the timing or amount of revenue we may recognize from quarter to quarter. With these dramatic quarterly fluctuations, it makes it difficult for management to plan for cash flow and capital expenditures, and difficult for investors to evaluate our results of operations. During fiscal 2011, we are planning to make additional investments in our technology infrastructure, operations and other areas of our business in an effort to become more competitive and to increase our revenue. These efforts will use significant amounts of time, effort and funding. These efforts may not be successful in generating additional revenue.
We have historically had working capital deficits. If our revenue does not increase, our losses may increase; cash and working capital position may decline.
We have had cash flow shortages and deficiencies in working capital in previous fiscal years. Although we ended fiscal 2010 with approximately $1,861,000 in cash and $469,000 in short-term investments and a positive working capital position of approximately $1,796,000, we had a net loss for the fiscal year and used approximately $654,000 in cash to fund operations. Unless revenue increases, we may experience losses and our cash and working capital positions may be adversely impacted through fiscal 2011. To improve our cash position, we are actively seeking to increase revenue and improve operating income. However, our continuing efforts to improve our cash position, reduce expenses and generate revenue may not be successful.
Our future capital requirements depend upon many factors, including, but not limited to:
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the timing and number of clinical trials by clients, the number of samples submitted to us for testing, and the amount of revenue generated from these tests;
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our ability to enter into and build relationships with new clients, and obtain additional projects from existing clients;
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capital expenditure requirements, including for research and development efforts, upgrading or replacing laboratory equipment and making investments in information technology;
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delays or early terminations of clinical testing agreements with clients;
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our plans to pursue additional business strategies;
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our ability to manage our cash flow, including reducing our expenses; and
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other business and economic factors that may occur from time to time.
None of these factors can be predicted with certainty. Additionally, if we desire to invest in our laboratory technology or research and development, we may require additional financing.
We depend on cash flows from operations to fund our debt obligations, and any shortfall in working capital could have a material adverse effect on our business and operations.
In fiscal 2010 we entered into a $4 million term loan (see “ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS”). The loan is due and payable over 48 months, requiring current monthly payments of principal and interest of $121,822 for the remaining term of the loan. We will need to generate sufficient working capital and cash flows from operations to pay our debt. Any inability to make our loan payments as they become due could result in an event of default under the loan documents, which could have a material adverse effect on our business. Upon an event of default, the holder of the secured debt could seek to foreclose on our assets or exercise any other remedies available to it, subject to the terms of the loan documents.
The loss of our key personnel could adversely affect our business.
Our success depends to a significant extent upon the efforts of our senior management team and other key personnel. The loss of the services of any such personnel could adversely affect our business. Also, because of the scientific and technical nature of our business, our success is dependent upon our ability to attract and retain technologically qualified personnel. There is substantial competition for qualified personnel, and an inability to recruit or retain qualified personnel may impact our ability to grow our business and compete effectively in our industry.
Business disruptions could impact our personnel; clients and suppliers; and could adversely affect our business.
Our well-trained staff and scientific professionals are instrumental to our business productivity and success. The loss of the services of any such personnel, due to short-term illness or pandemic could cause significant disruptions to our employee base and could adversely impact our ability to provide our services. Also, because of the scientific and technical nature of our business, our success is also dependent upon our clients and supplier’s ability to deliver study samples, chemical reagents and other supplies necessary to produce test results and data.
The majority of our services are performed at our main laboratory and, if our facility is affected by man-made or natural disasters, our business could be materially adversely affected.
We currently perform all of our clinical and biomarker development services in our laboratories located in Seattle, Washington. Any natural or man-made disaster, such as a fire or earthquake, could damage or destroy our equipment, cause substantial delays in our operations, and create significant expenses. Any temporary or extended shutdown of our laboratories would harm our ability to perform services for our clients and to operate our business. There is no assurance as to when or whether we could recover from a serious natural or man-made disaster. If we were to need to establish a new laboratory for our services, we would have to spend considerable time and money securing adequate space and building out the laboratory and necessary infrastructure, and we would also have to obtain new CLIA and CAP certifications, which would take a significant amount of time and could result in delays in our ability to begin operations. All of this could have a material adverse effect on our business, financial condition, and results of operations. Even though we carry business interruption insurance, this insurance may not compensate us fully from any loss we may incur relating to these interruptions.
Our ability to protect our intellectual property is essential to the growth and development of our products and services.
We rely, in part, on trade secrets and know-how to develop and maintain our competitive position and technological advantage on our existing intellectual property and any future intellectual property we develop. We protect our intellectual property through a combination of trademark, service mark, copyright, trade secret laws and other methods of restricting disclosure and transferring title. We have and intend to continue entering into confidentiality agreements with our employees, consultants and vendors; and generally seeking to control access to and distribution of our intellectual property. These methods may not be adequate to protect our intellectual property.
We are dependent on single-source suppliers.
We purchase certain chemical reagents used in our laboratory testing from many single source suppliers. If any of our suppliers were to become unwilling or unable to provide these materials in required quantities or on our required timelines, we would need to identify acceptable replacement sources. The disruption of such supply relationships could impair our ability to perform laboratory testing, result in contract delays or cause us to incur costs associated with the finding of alternative sources of supplies. We may not be able to identify and contract with acceptable replacement sources on a timely basis or on acceptable terms or at all. Any delays or difficulties with our suppliers could have a material adverse effect on our business and results of operations.
If our revenue or cash flow from operations does not increase, we may need to raise capital to fund operations in the future.
We used cash of approximately $654,000 in our operations during fiscal 2010. Although we anticipate that our cash, current assets and projected cash flows from operations will be sufficient to fund our business through fiscal 2011, this may prove inaccurate. Our business can change unpredictably due to a variety of factors, including competition, regulation, legal proceedings or other events, which could impact our funding needs or our cash flow from operations or increase our required capital expenditures. If our revenue or cash flow does not increase, or if unforeseen events arise, we may need to raise capital through equity or debt financing or through the establishment of other funding facilities in order to maintain operations. In the current market condition, raising capital has been, and may continue to be difficult, and we may not receive sufficient funding. Any future financing that we seek may not be available in amounts or at times when needed, or, even if it is available, may not be on favorable terms. Also, if we raise additional funds by selling equity or equity-based securities, the ownership of our existing stockholders will be diluted.
Any inability to obtain sufficient capital to fund operations when needed would have a material adverse effect on our financial position, results of operations and ability to continue in existence, and we could be forced to seek protection from creditors under the bankruptcy laws or cease operations. During fiscal 2011, we plan to make additional investments in our technology infrastructure, operations and other areas of our business in an effort to become more competitive and to increase our revenue. These efforts will use significant amounts of time, effort and funding.
We may consider strategic alternatives and acquisition or divestiture opportunities.
From time to time, we may consider strategic alternatives or other acquisition or divestiture opportunities, which could include merger, asset sale, joint venture or similar transaction. There are significant risks and uncertainties associated with acquisition or sales transactions. If we were to seek to grow by acquisition, factors which could affect the success of such a transaction include
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difficulties and expenses in connection with integrating the acquired companies and achieving the expected benefits,
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diversion of management’s attention from current operations,
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the possibility that we may be adversely affected by risk factors facing the acquired companies, and
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acquisitions could be dilutive to earnings, or in the event of acquisitions made through the issuance of our common stock to the stockholders of the acquired company, dilutive to the percentage of ownership of our existing stockholders.
Risks Relating to Our Industry
A decrease in research and development expenditures or outsourcing by pharmaceutical and biotechnology companies would adversely affect us.
Our revenue depends greatly on the expenditures made by the pharmaceutical and biotechnology industries in research and development, and particularly on the ability and willingness of these companies to outsource the services we provide. We are therefore subject to risks, uncertainties and trends that affect companies in these industries, including economic factors, availability of funding, and changes in research and development budgets. Research and development budgets fluctuate due to many factors, including changes in available resources, spending priorities, mergers of pharmaceutical and biotechnology companies, and institutional policies. A decrease in R&D expenditures or a decrease in outsourcing by pharmaceutical and biotechnology companies could materially adversely affect our business and results of operations.
The pharmaceutical and biotechnology industries movement to “adaptive clinical trials” may adversely affect our results of operations.
Recently, we have observed that our pharmaceutical and biotechnology clients have been shifting to “adaptive clinical trials”. These adaptive clinical trial protocols are designed to replace large, multi-year, multi-million dollar contracts. After each adaptive clinical trial phase, the pharmaceutical or biotechnology company reviews the results and decides whether to continue or discontinue the work, after which we may be awarded another small contract for another discrete clinical phase. Compared to our traditional contract business, these adaptive clinical trials are shorter in duration and with fewer test samples sent to us, resulting in a smaller dollar value contract. The major industry risk for us is cancellation of contracts for drug research and development studies outsourced to our company, and with adaptive clinical trial contracts, there are many more potential stopping points for the testing work. In addition, the complexity and additional work created by several start and stop and restart phases within the adaptive clinical trial model challenges profit margins through its requirement to use greater internal resources to complete the work. We anticipate that these adaptive clinical trials will require more project management time and efforts on our behalf, and will require us to increase our business development in order to bring in more, albeit smaller, contracts. If we are not able to effectively manage these shorter trials, or increase our business development, our business may be harmed. In addition, other risks and issues with these smaller trials is that patient recruiting is multiplied as well as sample collection, handling, and testing. While companies in these industries may actually increase the number of research and development projects they outsource via the use of adaptive clinical trials, our business could be materially adversely affected by nature of these many smaller increments of contract work outsourced to us.
We may be affected by changes in and trends affecting the pharmaceutical and biotechnology industries.
Our clients in the pharmaceutical and biotechnology industries have experienced significant consolidation over the last several years and we expect that trend to continue. The uncertainty caused by consolidation, before, during and after a business combination can result in product delays, changes in strategy, and consolidation and/or elimination of research and development efforts. Any of these effects can have a materially adverse affect on us.
In addition, management continues to review developments in the dyslipidemia drug development market that had previously provided the majority of our revenues. Over the last several fiscal years, we have observed a modest resurgence in the dyslipidemia pipeline and we are cautiously optimistic that this trend will continue, despite a downturn in the current fiscal year. Moreover, we have also observed a shift in emphasis in Pharma from pure “cholesterol drugs” towards drugs that treat type 2 diabetes and obesity, both of which are therapeutic areas in which we have considerable expertise. We will continue to be impacted by changes affecting the pharmaceutical and biotechnology industries.
Failure to keep pace with changes in the marketplace may cause us to lose market share and our revenue may decrease.
Clinical testing and biomarker services are subject to rapid technological change and innovation. In particular, laboratories are regularly developing new assays to incorporate into clinical testing and have to maintain up-to-date laboratory equipment to stay competitive. In developing and enhancing our services, we have made, and will continue to make, assumptions about which features; standards and performance criteria will be attractive to, or demanded by, our clients. We have noticed recently more companies that offer various types of biomarker services. If we implement criteria that are different from those required by our clients or if our competitors introduce products and systems that better address these needs, market acceptance of our offerings may suffer or may become obsolete. In that event, our market share and revenue would likely decrease. In addition, clients are requiring that laboratories maintain secure and sophisticated information technology systems, as a means for storing data and facilitating communication between the laboratory and the client. Although we continue to expend efforts and resources in these areas, we may not be successful in keeping up with client needs or expectations. In addition, if a client or prospective client has negative perceptions about our abilities, whether based on our financial strength or other factors, this may affect our ability to attract new clients or projects. Many of our competitors have greater resources than we do.
To be competitive in our industry, we need to successfully develop and market new services.
We continually seek to develop and market new services that complement or expand our existing business to increase our competitive position, diversify our client base, and increase the scope and number of our contracts. If the market for these services does not develop as we anticipate, we may not be successful in attracting new clients and generating revenue. In addition, these new services require management time and efforts, which may detract from our core business. If we are unable to develop new services and or create demand for those newly developed services, our future business, results of operations, financial condition and cash flows could be adversely affected.
We operate in a highly competitive industry, and we may lose or fail to attract clients for our services to our competitors.
Our competitors range from small, limited-service providers to full service global contract research organizations. Our main competition consists of in-house departments of pharmaceutical companies, full-service contract research organizations, and, to a lesser degree, universities. See “BUSINESS - Competition” above. We compete on a variety of factors, including
· technological expertise and efficient drug development processes,
· reputation for on-time quality performance,
· price,
· expertise and experience in specific therapeutic areas,
· strengths in various geographic markets and global reach,
· scope of service offerings,
· ability to acquire, process, analyze and report accurate data in a time-saving manner, and
· expertise and experience in health economics and outcomes services.
Many of our competitors have greater resources than we do, have global operations and greater name recognition. If we experience significant competition which is based on factors which we do not have in our business, such as global management of projects or size, our business could be materially adversely affected.
Changes in government regulations could decrease the need for our services.
Governmental agencies throughout the world, but particularly in the United States, highly regulate the drug development and approval process. See “BUSINESS - Government Regulation” above. Our business involves performing safety and efficacy laboratory testing during clinical trials of new pharmaceutical drugs. Clinical trial laboratory data is used by pharmaceutical and biotechnology companies in the submission process to the FDA for the marketing approval of a new drug. Changes in regulations, such as a relaxation in regulatory requirements or the introduction of simplified drug approval procedures or an increase in regulatory requirements that we have difficulty satisfying, could eliminate or substantially reduce the need for our services. Also, government efforts to contain drug costs and pharmaceutical and biotechnology company profits from new drugs may have an impact on the drug development and approval process, and our clients may spend less, or reduce their growth in spending, on research and development or outsourcing.
Healthcare reform could adversely affect our clients and could decrease the need for the services we provide and our revenues.
In recent years, governments of the United States, Europe and Asia have considered various types of health care reform in order to control growing health care costs. In addition, there are a number of initiatives on the federal and state levels for comprehensive reforms affecting the payment for, the availability of, and the reimbursement for healthcare services in the United States. The effects of these health care reforms will likely pose changes to the pharmaceutical and biotechnology industries. It is possible that they could limit the profits that can be made from the development of new drugs, or have the effect of putting downward pressure on the prices that pharmaceutical and biotechnology companies can charge for prescription drugs. This could result in pharmaceutical and biotechnology companies spending less on research and development or outsourcing, which could in turn decrease the business opportunities available to us. Alternatively, this could result in an increase in generic drugs which could provide increased opportunities for us. In addition, new laws such as the Affordable Health Care Act which became law in the United States on July 1, 2010 or other regulations may create a risk of liability, increase our costs or limit our service offerings. We cannot predict the impact of these healthcare reforms on our pharmaceutical and biotechnology clients and their drug development efforts, or the resulting impact on the number and size of clinical services we perform.
Failure to comply with existing government regulations or our CLIA and CAP certifications could result in a loss of revenue.
The clinical laboratory testing industry is subject to extensive regulation. Any failure on our part to comply with applicable government regulations could result in the termination of on-going research or sales and marketing projects or the disqualification of data for submission to regulatory authorities. Our laboratory is currently CLIA and CAP-certified. If we fail to comply with CLIA or CAP requirements, our license could be suspended or revoked, or our operations could be limited and we could become subject to significant fines and/or criminal penalties. In addition, if we fail to validate analytical test methods performed on samples collected during and in support of a trial or if we fail to comply with GCP (Good Clinical Practice) or GLP (Good Laboratory Practice) regulations, the generated test data could be disqualified. If this were to happen, we could be contractually required to repeat the trial at no further cost to our client, but at substantial cost to us. Any of this would harm our business and financial condition.
We must maintain certifications from our clients in order to be eligible to bid on projects.
Many of our clients require our laboratories to be audited from time to time for certification that we comply with their internal requirements. If we fail to comply or make adjustments in a timely fashion, we will probably be terminated from existing contracts and we will not be eligible to bid on that client’s future projects. While generally we have been very successful in maintaining certifications and in gaining new certifications, if we fail certification tests, especially for our major clients, our business would be materially adversely affected.
Specialty reference laboratory services create a risk of liability.
In contracting to work on drug development trials, we face a range of potential liabilities, including
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errors or omissions in laboratory data being generated relating to the safety and efficacy of the drug, that could affect the regulatory approval of the drug, and
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errors and omissions during a trial that may undermine the usefulness of a trial or data from the trial.
While we maintain what we believe is adequate insurance coverage and obtain contractual indemnifications protecting us against liability arising from our own actions (other than negligence or intentional misconduct), we could be materially and adversely affected if we were required to pay damages or bear the costs of defending any claim which is not covered by a contractual indemnification provision or which is beyond the level of our insurance coverage. Due to the rising costs of insurance, we may not be able to maintain such insurance coverage at levels or on terms acceptable to us.
Risks Related to Our Common Stock
Our common stock is traded on the OTC Bulletin Board and is considered a “penny stock”. Our stockholders’ ability to sell shares in the secondary trading market may be limited.
Our common stock is currently quoted for trading on the OTC Bulletin Board. As a result, the liquidity of our common stock is limited, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and the lack of coverage by security analysts and the news media of our company.
In addition, because our stock is quoted on the OTC Bulletin Board, our common stock is subject to certain rules and regulations relating to “penny stock.” A “penny stock” is generally defined as any equity security that has a price less than $5.00 per share and that is not quoted on the NASDAQ Stock Market or a national securities exchange. Being a penny stock generally means that any broker who wants to trade in our shares (other than with established clients and certain institutional investors) must comply with certain “sales practice requirements,” including delivery to the prospective purchaser of the penny stock a risk disclosure document describing the penny stock market and the risks associated therewith. In addition, broker-dealers must take certain steps prior to selling a “penny stock,” which steps include:
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obtaining financial and investment information from the investor;
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obtaining a written suitability questionnaire and purchase agreement signed by the investor; and
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providing the investor a written identification of the shares being offered and the quantity of the shares.
If these penny stock rules are not followed by the broker-dealer, the investor has no obligation to purchase the shares. The application of these comprehensive rules will make it more difficult for broker-dealers to sell our common stock, and as a practical matter, these requirements may mean that brokers are less likely to make recommendations on our shares to its general clients.
As a result, for as long as our common stock is quoted on the OTC Bulletin Board and subject to these penny stock rules, our stockholders may have difficulty in selling their shares in the secondary trading market. In addition, prices for shares of our common stock may be lower than might otherwise prevail if our common stock were quoted on the NASDAQ Stock Market or traded on a national securities exchange, like The New York Stock Exchange or American Stock Exchange. This lack of liquidity may also make it more difficult for us to raise capital in the future through the sale of equity securities.
Risks related to our common stock include, but are not limited to the following:
· our quarterly operating results may vary, and these fluctuations could affect the market price of our stock;
· our stock price is volatile and a stockholder’s investment in our common stock could suffer a decline in value; and
· the market for our stock has not been liquid.
If we issue additional equity securities in the future, the ownership of our existing stockholders will be diluted.
If we issue stock or convertible securities in the future, including for any future equity financing or upon exercise of any of the outstanding stock purchase warrants and stock options, those issuances would also dilute our stockholders. If any of these additional shares are issued and are sold into the market, it could decrease the market price of our common stock and could also encourage short sales. Short sales and other hedging transactions could place further downward pressure on the price of our common stock.
We do not intend to pay cash dividends, so any return on investment must come from appreciation.
We have not declared dividends on our common stock in the past, and do not intend to declare dividends on our common stock in the foreseeable future. As a result, any investment return in our common stock must come from increases in the fair market value and trading price of our common stock.
ITEM 1B
ITEM 1B UNRESOLVED STAFF COMMENTS
Not Applicable.
ITEM 2
ITEM 2 PROPERTIES
We lease approximately 15,000 square feet of office and primary laboratory space in Seattle, Washington for our executive offices and laboratory. The current monthly rent under the lease is $21,639, and the monthly rental rate increases approximately three percent on each November 1 for the remainder of the term. The lease term expires October 31, 2012.
We also lease approximately 1,030 square feet of office and laboratory space in a separate Seattle, Washington location for our biomarker services laboratory. Previously, our lease covered only 500 square feet, but on August 1, 2009, we entered into a new lease that increased the size of the leased space to approximately 1,030 square feet. The current monthly rent under the lease is $5,595. The lease term is 24 months and expires August 31, 2011.
In the opinion of management, the leased premises are adequately covered by insurance. We do not own any real property.
We have experienced space and power constraints with our existing premises. In addition, we would also like to consolidate our two laboratories under one location. Accordingly, we have engaged the services of a commercial real estate broker to assist us in locating suitable new office and laboratory space in the greater Seattle, Washington area. We do not currently have an agreement or negotiations underway for a new location. We anticipate that any such relocation will not occur until the fourth quarter of fiscal 2011 or the first quarter of fiscal 2012.
ITEM
LEGAL PROCEEDINGS
We are not a party to any material pending material legal proceedings.
ITEM
[REMOVED AND RESERVED]
PART II
ITEM
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Common Stock
Our common stock is currently quoted for trading on the OTC Bulletin Board under the symbol “PBMC.”
The following table shows, for each quarter of fiscal 2010 and 2009, the high bid and ask sales prices as reported by the OTC Bulletin Board. The quotations from the OTC Bulletin Board reflect inter-dealer prices without retail mark-up, mark-down, or commissions and may not represent actual transactions.
Holders
As of September 21, 2010, there were 16,669,856 shares of common stock issued and outstanding, held by approximately 136 holders of record.
Dividends
We have never declared or paid any cash dividends with respect to our common stock, and do not plan to do so in the foreseeable future. We anticipate that we will retain future earnings for use in the operation and expansion of our business. Any future determination with regard to the payment of dividends will be at the discretion of our board of directors and will be dependent upon our future earnings, financial condition, applicable dividend restrictions and capital requirements and other factors deemed relevant by the board.
Sales of Unregistered Securities
The following provides information regarding sales of equity securities by us during the fiscal year ended June 30, 2010, which were not registered under the Securities Act: None
ITEM
SELECTED FINANCIAL DATA
As a Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in Item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting obligations and therefore are not required to provide the information requested by this Item.
ITEM
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis in conjunction with our consolidated audited financial statements and related notes for the fiscal year ended June 30, 2010, included elsewhere in this Report. Except for historical information, the following discussion contains forward-looking statements. See “Cautionary Notice Regarding Forward Looking Statements” and “Risk Factors.”
Overview
We provide specialty reference laboratory services to support pharmaceutical and laboratory diagnostic manufacturers in the conduct of human clinical research, for use in their drug and diagnostic product development efforts. Our clients include a number of the world’s largest multi-national pharmaceutical, biotechnology and diagnostic companies Our well-recognized specialty areas include cardiovascular diseases (dyslipidemia, atherosclerosis, and coronary heart disease), diabetes, obesity, and rheumatology and bone diseases including osteoporosis as well as osteoarthirits and rheumatoid arthritis. We also provide clinical biomarker services for novel biomarkers, as well as custom assay services, to our pharmaceutical and biotech clients. Our company is a Delaware corporation, incorporated in May 1996, and we conduct our operations primarily through our wholly-owned subsidiary, Pacific Biomarkers, Inc., a Washington corporation.
Critical Accounting Estimates and Policies
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates including, among others, those affecting revenue, the allowance for doubtful accounts, and the useful lives of tangible and intangible assets. The discussion below is intended as a brief discussion of some of the judgments and uncertainties that can impact the application of these policies and the specific dollar amounts reported on our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, or if management made different judgments or utilized different estimates. Many of our estimates or judgments are based on anticipated future events or performance, and as such are forward-looking in nature, and are subject to many risks and uncertainties, including those discussed below and elsewhere in this Report. We do not undertake any obligation to update or revise this discussion to reflect any future events or circumstances.
We have identified below some of our accounting policies that we consider critical to our business operations and the understanding of our results of operations. This is not a complete list of all of our accounting policies, and there may be other accounting policies that are significant to our company. For a detailed discussion on the application of these and our other accounting policies, see Note 2 to the Consolidated Financial Statements included in this Report.
Revenue Recognition
Under fixed-price contracts, we recognize revenue as services are performed, with performance generally assessed using output measures, such as units-of-work performed to date compared to the total units-of-work contracted. Our client contracts may be delayed or cancelled at anytime. Uncertainty surrounding continuation of existing revenues during any period is high. We believe that recognizing revenue as services are performed is the most appropriate method for our business as it directly reflects services performed in the laboratory. We would expect material differences in reporting of our revenues to occur if we changed our assumptions for revenue recognition from services performed to other methods such as percent complete or completed contract methods. While both other methods are allowed under Generally Accepted Accounting Principals, they would introduce more variables and estimates into our revenue recognition process. The percent complete method introduces estimated costs early in the process that may drive revenues higher in early periods and should the study be terminated early, previously recognized revenue would be reversed, net of a cancellation fee, if applicable. The completed contract method may recognize revenues in future contract periods, such as the first quarter after a fiscal year close and subsequent to completion of the services rendered.
Fair Value Measurements - Debt Financing
We follow ASC Topic 820 and 825, (SFAS 157, Fair Value Measurements) in determining the fair value in our recent repurchase of shares of common stock. SFAS 157 clarifies a number of considerations with respect to fair value measurement objectives for financial reporting and expands disclosures about the use of fair value measurements. The degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information. See Note 8 to our Consolidated Financial Statements. In valuing the repurchased shares from our $4 million debt financing in September 2009, we chose a bid-ask regression model as the most appropriate method to determine the fair value of these shares. We would expect material differences in reporting of the fair value of these shares, had we chosen other methods in determining the fair value. The discount to the Note derived from the fair value of the shares and interest expense derived from the discount may have been a higher or lower amount. For example, a regression model based on restricted share regression analysis would produce a higher discount amount. Alternatively, had we chosen the market closing price for fair value, the discount would have been zero. However, due to the thin trading characteristics of our stock within the OTCBB market, the number of shares repurchased, other observable and unobservable inputs, it was our judgment that the method utilized in estimating the fair value of these shares was appropriate for this transaction.
Stock-Based Compensation
We report stock-based compensation expense applying ASC Topic 718 (SFAS No. 123(R), Share-Based Payment), using the modified prospective transition method. This requires us to estimate the fair value of our equity-based awards on the date of grant using an option-priced model. This also requires us to estimate the number of equity awards that will ultimately vest and those that will be forfeited. We record on our consolidated income statements the fair value of the portion of the award that is expected to vest, which we expense over the requisite service periods. Determining the fair value of equity-based awards at the grant date requires judgment, particularly in applying the volatility assumptions used in the Black-Scholes pricing model. With the recent volatility in the stock market, our volatility assumptions changed significantly for fiscal 2010 (148-151%) from fiscal 2009 (108.8%). See Note 2 to Consolidated Financial Statements. In addition, judgment is also required in estimating the amount of equity-based awards that are expected to be forfeited, which we base on actual historical data, typically over the past three years. Our current estimates are that only 2-4% of the awards will be forfeited. If we were to estimate a higher percentage of forfeitures, we would recognize a lower amount of stock based compensation expense as of the date of the grant. If actual forfeitures are significantly fewer less than our estimate, we would have to record additional equity-based compensation expense; conversely, if there are more forfeitures than we estimated, we would have to reverse previously recognized expense.
Useful Lives of Tangible Assets
The assets we acquire are subject to our best estimates of useful lives of the asset for depreciation and amortization purposes. We depreciate equipment and computers over three to five years, and we depreciate leasehold improvements over the lesser of the remaining life of the lease or ten years. In management’s judgment, these useful life periods reflect a reasonable estimate of the life over which we will use the equipment, computers and leasehold improvements. We capitalize software costs incurred in connection with obtaining and developing internal use software (“software costs”) in accordance with ASC Topic 350-40 (formerly Statement of Position (SOP) No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use). We amortize software costs over a period not to exceed three years. Under GAAP, we could have used other useful life periods for depreciation and amortization. A longer period, such as seven years for equipment and software costs, would result in smaller depreciation and amortization expense and higher property and equipment values on our balance sheet. We believe the useful life periods that we use are reasonable.
The amount of depreciation and amortization expense we record in any given period will change if our useful life estimates were to increase or decrease. In addition, from time to time we may determine that we no longer have use for a certain tangible or intangible asset. This may be because an asset was used exclusively for a study that has been cancelled, or because of changes in scientific methods for our testing. We use the discounted cash flow method according to ASC Topic 360 (formerly SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets) to test our assets for impairment. If we were to determine that any of our assets were impaired or have a reduced useful life, we would have to take a charge against current earnings.
Results of Operations for the Fiscal Years Ended June 30, 2010 and 2009
Revenue:
We generate the majority of our revenue from clinical pharmaceutical trials testing (“traditional biomarker services”) and novel biomarker development services. We also provide diagnostic services, which historically have represented less than 1% of our total revenue.
Our revenue decreased approximately 11% to $9,665,000 from $10,881,000 for the comparable fiscal years ended June 30, 2010 and 2009. In fiscal 2010 our revenue was negatively impacted by delays and cancellations of testing in the diabetes and rheumatoid arthritis therapeutic areas. Our revenue fluctuates due to the variability in the volume of testing services we perform, by the timing between actual receipt of test samples and scheduled testing, pace of the clinical trial itself, open work orders and prior work orders having been completed or terminated. We also experienced a large reduction in revenue sourced from other large clinical laboratories that refer specialty laboratory testing to us (“Referral Laboratory Partners”). In contrast, during fiscal 2009 we benefited from strong levels of testing revenue in the same therapeutic areas and from our Referral Laboratory Partners.
We believe that the overall decrease in revenue for the year ended June 30, 2010 reflects ongoing uncertainty in the drug development marketplace, including cancellations and delays. We are continuing to monitor and evaluate the shift in the industry to “adaptive clinical trials” and how this change is impacting us now as well as going forward. In fiscal 2010 we experienced a 25% decrease in revenues from our work with Referral Laboratory Partners. Several of our Referral Laboratory Partners have reported decreases in their revenue from central lab services during our fiscal year that directly affect our revenue. We believe this is responsible for the significant 7% downward shift in this revenue category as a percentage of total revenue, as noted in the chart below.
While we added staff in our business development area during fiscal 2010, approximately half of our study contracts signed during the fiscal year did not result in recognized revenue in the fiscal year but added to our contract backlog. The primary component of our business development efforts has been directed towards pharmaceutical and biotech companies, which includes our biomarkers business (“Direct Clinical Services”) which showed an 8% increase over fiscal 2009 as a percentage of total revenue, but due to a decrease in total revenue represents no increase in revenue dollars. Biomarker services showed a 2% increase as a percentage of total revenue, but an 11% increase in dollars. Although the growth of our biomarker services has been slower than we originally expected, this area is a primary focus of our business and we believe it addresses a rapidly growing sector of laboratory services for clinical drug development. As a result, we expect to see our biomarker services to continue to grow and to represent a larger portion of our revenue during fiscal 2011.
The following table provides a breakdown of the percentage of our total revenue generated from each of our service areas for the past two fiscal years:
Our revenues tend to fluctuate from quarter to quarter, and at times these fluctuations are significant. These fluctuations are clearly observed in the first, second and third fiscal quarters of 2010 compared to the comparable quarters in fiscal 2009, where revenue increased 27% in the first quarter, decreased 35% in the second quarter and decreased 22% in the third quarter. In contrast, for the first, second and third quarters of fiscal 2009 revenue increased 96%, 24% and 34% compared to the comparable quarters in fiscal 2008. The following table shows the significant swings in our quarterly revenue for each quarter in the past three fiscal years:
Once our work on a study commences, the client may cancel the study at any time during the testing phase. Clients may terminate, delay, or change the scope of a project for a variety of reasons including unexpected or undesirable clinical results or a decision to forego a particular study. Accordingly, our revenues may be significantly affected by the success or failure of the testing phase and other factors outside of our control, including a large number of pharmaceutical companies’ cost reduction announcements and continuing consolidation in the biopharmaceutical market.
Operating Expenses
Historically, we have segregated our recurring operating expenses between two categories: laboratory and cost of goods sold and selling, general and administrative expenses, which includes research and development. Laboratory expenses and cost of goods sold consist of amounts necessary to complete the revenue and earnings process, and includes direct labor and related benefits, other direct costs, and an allocation of facility charges and information technology costs, and depreciation and amortization. Also, laboratory expenses and cost of goods sold include shipping and handling fees and reimbursable out-of-pocket costs. Laboratory expenses and cost of goods sold, as a percentage of net revenue, tends, and is expected, to fluctuate from one period to another, as a result of changes in labor utilization and the mix of service offerings involving studies conducted during any period of time. Selling, general and administrative expenses include business development activities, sales and marketing expenses, laboratory administration expenses and research and development activities through our science and technology department. Selling, general and administrative expenses consist primarily of administrative payroll and related benefit charges, legal and accounting fees, advertising and promotional expenses, administrative travel and an allocation of facility charges, information technology costs, and depreciation and amortization.
Laboratory Expense and Cost of Goods Sold:
We categorize under “laboratory expense and cost of goods sold” certain operating expenses that are necessary to complete the revenue and earnings process. These expenses consist primarily of direct labor costs and related benefits of employees performing analysis of clinical trial samples, and the cost of chemical reagents and supplies for analysis of clinical trial samples, and secondarily, of payments to subcontractors for laboratory services, an allocation of facility charges and information technology costs, insurance, business and occupation taxes, shipping and handling fees and reimbursable out-of-pocket costs. For the comparable fiscal years ended June 30, 2010 and 2009, laboratory expense and cost of goods sold decreased approximately 1% to $5,858,000 from $5,920,000.
As a percentage of revenue, laboratory expense and cost of goods sold fluctuate from period to period as a result of changes in labor utilization and the mix of service offerings. For the comparable fiscal years 2010 and 2009, laboratory expense and cost of goods was approximately 61% and 55% as a percentage of revenue, which reflects our decrease in revenue.
In 2010, we had expense increases primarily related to biomarker services in salaries and related benefits and fixed costs; including an increase in rent from our expanded laboratory for biomarker development (total occupied square footage in fiscal 2010 increased 97% compared to fiscal 2009). These increases were offset by decreases in bonus expense, reagent costs and expenses for outside services. Our bonus expense decreased because the performance targets were not fully achieved in fiscal 2010. The following table illustrates changes in Laboratory Expenses and Cost of Goods Sold in fixed and variable expense categories:
The largest component of laboratory expense during fiscal 2010 was salaries and related benefits. During the fiscal years ended June 30, 2010 and 2009, salaries and related benefits increased by 10% to approximately $2,630,000 from $2,391,000 as a result of an increase in staff from 44 FTE to 46 FTE and one transfer from our science and technology department to the biomarker services laboratory to accommodate the increasing complexity of the tests performed and development of new capabilities in the biomarker services area. During the fiscal years ended June 30, 2010 and 2009 salaries and related benefits were 28% and 22% of our revenue and accounted for approximately 45% and 40% of total laboratory expense and cost of goods sold.
The other major component of laboratory expense during fiscal 2010 was the cost of laboratory reagents and supplies for analysis of clinical trial samples. During the fiscal years ended June 30, 2010 and 2009, laboratory reagents and supplies decreased by 18% to approximately $1,972,000 from $2,402,000 as a result of a decrease in the number of tests performed. These expenses are also affected by our novel biomarker business as it requires significantly less laboratory reagents and supplies to operate. Over the last three fiscal years, reagent chemicals used in our laboratory testing have averaged approximately 20% in cost as a percentage of revenue, but may vary considerably depending on the type of specific testing we perform, and constitute a significant expense item for our business. In contrast, reagent and laboratory supply expenses for our biomarker services are approximately 3-5%, as a percentage of revenue. During the fiscal years ended June 30, 2010 and 2009 laboratory supplies were approximately 20% and 22% of our revenue and accounted for approximately 34% and 41% of total laboratory expense and cost of goods sold.
Another component of laboratory expense during fiscal 2010 was other variable costs. Other variable costs decreased 9% to approximately $562,000 from $616,000 during the fiscal years ended June 30, 2010 and 2009. The major reason for this decrease was a decrease in our expenses for outside services that consists mainly of contracted laboratory services.
Fixed costs for the fiscal year ended June 30, 2010 increased 36% compared to the fiscal year ended June 30, 2010, to approximately $694,000 from $511,000. This overall increase was mainly due to increases in depreciation expense from our purchasing several new instruments for the laboratory during the fiscal year, rent due to our expansion of our biomarker facility and liability insurance expense.
Selling, General and Administrative Expense:
We categorize under “selling, general and administrative expenses” operating costs associates with our business development activities, sales and marketing, laboratory administration and research and development activities through our science and technology department. Our selling, general and administrative expense consists primarily of administrative payroll and related benefits (including compensation for our executive officers, board members and administrative personnel in business development, laboratory administration, and our science and technology department), and secondarily of share-based compensation, business development expenses, legal, accounting and public company expenses.
For the comparable years ended June 30, 2010 and 2009 selling, general and administrative expense increased approximately 7% to approximately $4,643,000 from $4,347,000. As a percentage of revenue, selling, general and administrative expenses were approximately 48% and 40%, respectively, for the comparable fiscal years ended June 30, 2010 and 2009, which reflects our decrease in revenue.
The dollar increase in our selling, general and administrative expenses for the comparable periods is due in large part to increases in salaries and related benefits, due to the addition of two FTEs in business development and one FTE in administration. Other SG&A increases occurred in legal expenses, public company expenses and expenses for outside consultants. These increases were offset somewhat by decreases in accounting expense, bad debt expense and bonus expense. Our bonus expense decreased because the performance targets were not fully achieved in fiscal 2010.
Other Income/(Expense):
We had other expense of approximately $547,000 for the fiscal year ended June 30, 2010, compared to other income of approximately $623,000 for the fiscal year ended June 30, 2009. For the fiscal year ended June 30, 2010, we had interest expense of approximately $399,000 related to our $4 million debt financing from September 2009 and approximately $63,000 of amortization expense for the discount on the debt, plus approximately $84,000 of other interest expense.
In contrast, for fiscal 2009, we had only $158,000 in interest expense and, significantly, we incurred a one-time non-cash gain of approximately $676,000 due to the accounting treatment on the Laurus convertible notes, which were paid in full as of December 31, 2008. We had no comparable gain in fiscal 2010.
Net Income (Loss):
We had a net loss of approximately $1,383,000 for the fiscal year ended June 30, 2010, compared to net income of approximately $1,236,000 for the fiscal year ended June 30, 2009. The decrease to net loss, from net income, is attributable to our reduced operating income and the gain derived from the Laurus convertible notes (as described above in “Other Income (Expense)”), whereas we had no similar non-cash gain in fiscal 2010. Other changes, such as increases in expense, affecting our net loss, are described above under “Laboratory Expense and Cost of Goods Sold” and “Selling, General and Administrative Expense.”
Liquidity and Capital Resources:
At June 30, 2010 our cash and cash equivalents were approximately $1,861,000, compared to approximately $1,365,000 at June 30, 2009. We also had approximately $469,000 invested in short-term marketable securities at June 30, 2010 and we had no short-term marketable securities at June 30, 2009. At June 30, 2010, we had approximately $1,853,000 in accounts receivable, compared to approximately $2,239,000 as of June 30, 2009, reflecting timing of revenues billed and collected. Our accounts receivable generally reflect our billings, and may include one or several individually large customer receivables from time to time. We generally have a high collectability rate on our accounts receivable, and our allowance for doubtful trade accounts is approximately $34,000, which we believe is reasonable based on our past experience.
Total liabilities recorded on our balance sheet as of June 30, 2010 were approximately $5,930,000 compared to approximately $1,986,000 as of June 30, 2009. This significant increase in liabilities was the result of our $4 million debt financing in September 2009. The loan is due and payable over 48 months, with the first 8 months being interest only ($40,000 per month) beginning September 30, 2009, and thereafter (beginning May 31, 2010) 40 monthly payments of principal and interest ($121,822 per month). During the first 12 months of the term of the loan, we had the right, in our sole discretion, to obtain an additional $500,000 loan from the lender on the same terms. We chose not to exercise this additional loan right. We do not have a bank line of credit or other general borrowing facility.
At June 30, 2010, we had working capital of approximately $1,796,000, compared to approximately $2,459,000 at June 30, 2009. Although we had a significant increase (approximately $496,000) in our cash and cash equivalents, this positive impact on our working capital was offset by the current portion (approximately $1,016,000) of our $4 million debt financing, by a decrease (by approximately $386,000) in our accounts receivable and an increase (by approximately $253,000) in short-term client advance primarily due to reclassified client advance funds that may be refunded to the client during fiscal 2011. Other changes providing a positive impact in working capital included increases in inventory and decreases in accounts payable and accrued liabilities. Other changes providing a negative impact included increases in capital lease obligations.
Net cash used by operating activities was approximately $654,000 for the fiscal year ended June 30, 2010 and included the effect of approximately $344,000 in depreciation and amortization, $112,000 in expense from share-based compensation and $63,000 in amortization of fair value assigned to repurchased shares of common stock, related to the debt financing. Our investing activities used cash of approximately $786,000 for the fiscal year ended June 30, 2010 for investments and the purchase of capital equipment. Cash flow provided by or used in financing activities included $4,000,000 provided by gross loan proceeds; and approximately $1,674,000 of those funds were used in a common stock repurchase. Additional cash flow used in financing activities included $164,000 for payments on debt, $160,000 for payments on capital lease obligations and $66,000 in payment of employee withholding taxes from transferred restricted stock.
We believe that our cash, current assets and cash flows from operations will be sufficient to fund current operations through the 2011 calendar year.
During fiscal 2011, we will continue to actively pursue business development and marketing activities to broaden our client and revenue base. In particular, we anticipate making additional capital investments for our clinical biomarker services. We may also invest from time to time in our technology infrastructure, operations and other areas of our business. These efforts will use significant amounts of time, effort and funding. We also anticipate that we will incur relocation and build-out costs in late fiscal 2011 or early fiscal 2012, assuming we are successful in finding and negotiating a lease for new office and laboratory space. In addition, our overall lease expenses may increase.
We will also continue to explore other strategic alternatives, which may include a merger, acquisition, asset sale, joint venture or other similar transaction with one or more strategic partners to provide additional capital resources to fund operations and growth opportunities.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
ITEM 7A
ITEM 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not Applicable.
ITEM
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is set forth in our Consolidated Financial Statements and Notes thereto beginning at page of this Annual Report on Form 10-K.
ITEM
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
CONTROLS AND PROCEDURES
Disclosure Control and Procedures
We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is (a) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (b) accumulated and communicated to management, including our Chief Executive Officer and Vice President and Controller, as appropriate, to allow timely decisions regarding required disclosure.
As required by Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures. This evaluation was carried out under the supervision and with the participation of our management, including our Chief Executive Officer and Vice President and Controller. Based upon that evaluation, management and our Chief Executive Officer and Vice President and Controller concluded that our disclosure controls and procedures are effective at June 30, 2010.
A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected.
There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the fourth quarter of fiscal 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
In response to the Sarbanes-Oxley Act of 2002, we are continuing a comprehensive review of our disclosure procedures and internal controls and expect to make minor modifications and enhancements to these controls and procedures. Management continually reviews, modifies and improves its systems of accounting and controls in response to changes in business conditions and operations and in response to recommendations in reports prepared by the independent registered public accounting firm and outside consultants.
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)).Under the supervision and with the participation of our management, including our Chief Executive Officer and Vice President and Controller, we conducted an evaluation of our internal control over financial reporting as of June 30, 2010, based on the framework in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, management concluded that our internal control over financial reporting was effective as of June 30, 2010.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
This Annual Report on Form 10-K does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to recent federal legislation (the Dodd-Frank Wall Street Reform and Consumer Protection Act) that exempts nonaccelerated filers from this obligation.
/S/ Ronald R. Helm
/S/ John P. Jensen
Ronald R. Helm
Chief Executive Officer
John P. Jensen
Vice President and Controller
THE FOREGOING MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING SHALL NOT BE DEEMED TO BE “FILED” WITH THE SEC, NOR SHALL SUCH INFORMATION BE INCORPORATED BY REFERENCE INTO ANY PAST OR FUTURE FILING UNDER THE SECURITIES ACT OR THE EXCHANGE ACT, EXCEPT TO THE EXTENT WE SPECIFICALLY INCORPORATE IT BY REFERENCE INTO SUCH FILING.
ITEM 9B
OTHER INFORMATION
On September 13 2010, we entered into an amendment of our employment agreement with Ronald R. Helm, our Chief Executive Officer. Under this amendment, to be effective October 1, 2010, we (a) extended his employment agreement through September 30, 2012 and (b) agreed to grant to him stock options for 600,000 shares of common stock on October 1, 2010. The stock options vest monthly over a period of three years from the grant date, and will have an exercise price equal to the closing market price on the grant date.
PART III
ITEM
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information called for by Part III, Item 10, is included in our proxy statement relating to our 2010 annual meeting of stockholders, and is incorporated herein by reference to the sections captioned “Directors and Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Board Meetings and Committees,” “Audit Committee,” “Policy on Stockholder Nomination of Directors” and “Code of Ethics”. The proxy statement will be filed on or before October 28, 2010 (within 120 days of June 30, 2010, our fiscal year end).
ITEM
EXECUTIVE COMPENSATION
Information called for by Part III, Item 11, is included in our proxy statement relating to our 2010 annual meeting of stockholders, and is incorporated herein by reference to the section captioned “Executive Compensation.” The proxy statement will be filed on or before October 28, 2010 (within 120 days of June 30, 2010, our fiscal year end).
ITEM
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Certain information called for by Part III, Item 12, is included in our proxy statement relating to our 2009 annual meeting of stockholders, and is incorporated herein by reference to the section captioned “Principal Stockholders.” The proxy statement will be filed on or before October 28, 2010 (within 120 days of June 30, 2010, our fiscal year end).
Equity Compensation Plan Information
The following table gives information as of June 30, 2010, regarding our common stock that may be issued upon the exercise of options, warrants and other rights under our equity compensation plans. See also “Note 10 to Consolidated Financial Statements” to our Consolidated Financial Statements for the fiscal year ended June 30, 2010 included in this report.
(1)
Consists solely of our 1996 Stock Incentive Plan. The Plan has been terminated and no additional shares or options may be awarded, but outstanding options and awards previously granted under the 1996 Plan continue in accordance with their terms.
(2)
Consists solely of our 2005 Stock Incentive Plan.
ITEM
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information called for by Part III, Item 13, is included in our proxy statement relating to our 2010 annual meeting of stockholders, and is incorporated herein by reference to the section captioned “Related-Party Transactions.” The proxy statement will be filed on or before October 28, 2010 (within 120 days of June 30, 2010, our fiscal year end).
ITEM
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information called for by Part III, Item 14, is included in our proxy statement relating to our 2010 annual meeting of stockholders, and is incorporated herein by reference to the sections captioned “Policy for Approval of Audit and Permitted Non-Audit Services” and “Audit and Related Fees.” The proxy statement will be filed on or before October 28, 2010 (within 120 days of June 30, 2010, our fiscal year end).
PART IV
ITEM
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Documents filed as part of this Report are as follows:
1. Financial Statements: The following consolidated financial statements, related notes and report of independent registered public accounting firm are incorporated by reference into Item 8
Item 8 of Part II of this Annual Report on Form 10-K for the fiscal year ended June 30, 2010:
2. Financial Statement Schedules: All schedules have been omitted because they are not applicable or not required, or the required information is included in the financial statements or notes thereto.
3. Exhibits.
Exhibit
No.
Description
3.1
(1)
Second Amended and Restated Certificate of Incorporation of the Company, dated December 15, 2009
3.2
(2)
Amended and Restated By-Laws of the Company
4.1
(2)
Specimen Stock Certificate
10.1A
(3)
Stock Incentive Plan, as amended
10.1B
(4)
Form of stock option agreement (for employees and officers) under 1996 Stock Incentive Plan
10.1C
(4)
Form of stock option agreement (for directors) under 1996 Stock Incentive Plan
10.2A
(5)
Stock Incentive Plan
10.2B
(6)
Form of stock option agreement under 2005 Stock Incentive Plan
10.2C
(7)
Form of restricted stock award agreement under 2005 Stock Incentive Plan
10.3A
(8)
Executive Employment Agreement, dated June 1, 2006, between the Company and Ronald R. Helm
10.3B
(9)
First Amendment to Executive Employment Agreement, between the Company and Ronald R. Helm, dated August 30, 2006
10.3C
(10)
Second Amendment to Executive Employment Agreement, between the Company and Ronald R. Helm, dated October 19, 2007
10.3D
(11)
Third Amendment to Executive Employment Agreement, between the Company and Ronald R. Helm, dated September 24, 2008
10.3E
(22)
Fourth Amendment to Executive Employment Agreement, between the Company and Ronald R. Helm, dated September 14,
10.3F
**
Fifth Amendment to Executive Employment Agreement, between the Company and Ronald R. Helm, dated September 13, 2010
10.4 ++
(12)
Employment Agreement, dated October 1, 2004, by and between the Company and Dr. Elizabeth Leary
10.5A
(13)
Office Lease, dated April 23, 1997, between Tom Kane and Elsa Kane and the Company
10.5B
(14)
First Amendment to Office Lease, dated January 20, 1998
10.5C
(14)
Second Amendment to Office Lease, dated April 20, 2007
10.6
(22)
Lease Agreement dated August 14, 2009, between Pacific Northwest Research Institute and the Company
10.7
(15)
Loan and Security Agreement, dated September 1, 2009, between the Company and Terry M. Giles
10.8
(15)
Term Note, dated September 1, 2009 by the Company in favor of Terry M. Giles
10.9
(15)
Subsidiary Guarantee, dated September 1, 2009, by the Company, Pacific Biomarkers, Inc., PBI Technology, Inc., and BioQuant, Inc. for the benefit of Terry M. Giles
10.10
(15)
Stock Redemption Agreement, dated September 1, 2009, between the Company and Terry M. Giles
10.11
(16)
Common Stock Purchase Warrant, dated May 28, 2004, issued by the Company in favor of Laurus Master Fund, Ltd. for 681,818 shares of common stock.
10.15
(21)
Form of Common Stock Purchase Warrant for March 2006 private placement
14.1
(4)
Code of Ethics for Financial Officers
21.1
(1)
Subsidiaries of the Company
23.1
**
Consent of PMB Helin Donovan, LLP
31.1
**
Certification by Ronald R. Helm, Chief Executive Officer
31.2
**
Certification by John P. Jensen, Vice President and Controller
32.1
**
Certification by Ronald R. Helm, Chief Executive Officer and John P. Jensen, Vice President and Controller, of Pacific Biomarkers, Inc., pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
**
Filed herewith
++
Portions of the marked exhibit have been omitted pursuant to a request for confidential treatment filed with the SEC.
(1)
Incorporated by reference to Exhibits of Registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2009, filed on February 11, 2010.
(2)
Incorporated by reference to Exhibits of Registrant’s Pre-Effective Amendment No. 1 to Registration Statement on Form SB-2, Registration No. 333-11551, filed on October 11, 1996.
(3)
Incorporated by reference to Exhibits of Registrant’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2003, filed on September 29, 2003.
(4)
Incorporated by reference to Exhibits of Registrant’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2004, filed on September 23, 2004.
(5)
Incorporated by reference to Appendix A of Registrant’s Definitive Proxy Statement on Schedule 14A filed on October 25, 2005.
(6)
Incorporated by reference to Exhibits of Registrant’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2006, filed on October 3, 2006.
(7)
Incorporated by reference to Exhibits of Registrant’s Quarterly Report on Form 10-QSB for the quarter ended December 31, 2007, filed on February 13, 2008.
(8)
Incorporated by reference to Exhibit of Registrant’s Current Report on Form 8-K filed on June 7, 2005.
(9)
Incorporated by reference to Exhibit of Registrant’s Current Report on Form 8-K filed on September 5, 2006.
(10)
Incorporated by reference to Exhibits of Registrant’s Quarterly Report on Form 10-QSB for the quarter ended September 30, 2007, filed on November 14, 2007.
(11)
Incorporated by reference to Exhibit of Registrant’s Annual Report on Form 10-K filed on September 26, 2008.
(12)
Incorporated by reference to Exhibits of Registrant’s Quarterly Report on Form 10-QSB for the quarter ended September 30, 2004, filed on November 15, 2004.
(13)
Incorporated by reference to Exhibits of Registrant’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 1997, filed on September 29, 1997.
(14)
Incorporated by reference to Exhibits of Registrant’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2007, filed on October 5, 2007.
(15)
Incorporated by reference to Exhibit of Registrant’s Current Report on Form 8-K filed on September 2, 2009.
(16)
Incorporated by reference to Exhibits of Registrant’s Current Report on Form 8-K filed on June 7, 2004.
(17)
Incorporated by reference to Exhibits of Registrant’s Current Report on Form 8-K filed on February 1, 2006.
(18)
Incorporated by reference to Exhibit of Registrant’s Current Report on Form 8-K filed on May 10, 2005.
(19)
Incorporated by reference to Exhibits of Registrant’s Registration Statement on Form SB-2, Registration No. 333-116968, filed on June 29, 2004.
(20)
Incorporated by reference to Exhibit of Registrant’s Current Report on Form 8-K filed on November 7, 2005.
(21)
Incorporated by reference to Exhibit of Registrant’s Current Report on Form 8-K filed on March 13, 2006.
(22)
Incorporated by reference to Exhibit of Registrant’s Annual Report on Form 10-K for the fiscal year ended June 30, 2009, filed on September 25, 2009.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on September 23, 2010.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
PACIFIC BIOMARKERS, INC.
Form 10-K Annual Report
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Stockholders of Pacific Biomarkers, Inc.
We have audited the accompanying balance sheets of Pacific Biomarkers, Inc. as of June 30, 2010 and 2009, and the related statements of operations, stockholders’ equity, and cash flows for each of the years in the two-year period ended June 30, 2010. Pacific Biomarkers, Inc.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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 Pacific Biomarkers, Inc. as of June 30, 2010 and 2009, and the results of its operations and its cash flows for each of the years in the two-year period ended June 30, 2010, in conformity with accounting principles generally accepted in the United States of America.
/s/ PMB Helin Donovan, LLP
PMB Helin Donovan, LLP
Spokane, WA
September 23, 2010
PACIFIC BIOMARKERS, INC.
CONSOLIDATED BALANCE SHEETS
As of June 30,
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC BIOMARKERS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended June 30,
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC BIOMARKERS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended June 30,
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC BIOMARKERS, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC BIOMARKERS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Basis of Presentation
Pacific Biomarkers, Inc., a Delaware corporation (“PBI” or the “Company”), provides specialty reference laboratory services to the pharmaceutical and diagnostics industries. The Company was incorporated in Delaware in May 1996. The Company conducts its business primarily through its wholly-owned subsidiary, Pacific Biomarkers, Inc., a Washington corporation. The Company’s two other wholly-owned subsidiaries are PBI Technology, Inc., a Washington corporation, and BioQuant, Inc., a Michigan corporation. All material intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements. All references in this report to “we,” “our,” “us” or similar expressions are to the Company and its wholly-owned subsidiaries.
2. Summary of Significant Accounting Policies
Principles of Consolidation
These consolidated financial statements include our consolidated financial position, results of operations, and statements of stockholders’ equity and cash flows. All material intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.
Cash and Cash Equivalents
Cash and cash equivalents consist of highly liquid investments with an original maturity of three months or less when purchased.
Short-term bank deposit
Bank deposits with original maturities of more than three months but less than one year are presented as part of short-term investments. Deposits are presented at their cost including accrued interest. Interest on deposits is recorded as financial income.
Accounts Receivable
Trade accounts receivable are stated at amounts billed to and due from clients, net of an allowance for doubtful accounts. Credit is extended based on evaluation of a client’s financial condition, and collateral is not required. In determining the adequacy of the allowance, management identifies specific receivables for which collection is not certain and estimates the potentially uncollectible amount based on the most recently available information. We write off accounts receivable when they are determined to be uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. At June 30, 2010, we deemed no accounts receivable uncollectible.
Other accounts receivable consist of non-trade receivables such as state business and occupation tax refunds, notes receivable and employee advances. These receivables are stated at amounts per invoice or agreement and due from other parties, net of an allowance for doubtful accounts. They are evaluated with the same methods as utilized for trade accounts receivable. At June 30, 2010 and 2009, we had $6,500 and $9,000 in other receivables, respectively.
The balance of the bad debt allowance was approximately $34,000 for the fiscal years ended June 30, 2010 and June 30, 2009.
Inventory
Inventory is stated the lower of cost or market. Cost is determined on a first in, first out (FIFO) basis. Our inventory consists of chemical reagents used in our laboratory testing.
Long -Lived Assets
Property and equipment are recorded at cost. Depreciation is provided using the straight-line method over the useful lives of the related assets, which range from three to five years. Leasehold improvements are amortized over the shorter of the estimated useful life of the improvements or the remaining term of the lease. The cost and related accumulated depreciation of property or equipment sold or otherwise disposed of are removed from the accounts and the resulting gains or losses are included in the statement of operations.
In accordance with the US GAAP, all of our long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recovered. If the sum of the expected future cash flows is less than the carrying amount of the asset, a loss is recognized. As of June 30, 2010 and 2009, no impairment was deemed necessary.
Client Advances
We receive advances from certain clients to perform consulting, laboratory services, and clinical studies. We apply these advances as payments to invoices as work is completed until the amounts advanced are exhausted. Advances are also applied to invoices for setup and administrative fees, billed upon contract approval. These setup and administrative fees are deferred as unearned income when billed and amortized over the life of the project. As of June 30, 2010, approximately $272,000 was reclassified to short-term client advance for a study that was determined inactive in the U.S., though still active in European trials. Should testing not resume with us during fiscal 2011, these monies will be refunded to the client.
Treasury Stock
Shares of common stock repurchased by us are recorded at cost and are included as a separate component of stockholders’ equity. We repurchased 2,391,906 shares of our common stock having a fair value of $1,468,609 for the fiscal year ended June 30, 2010. In addition, 91,132 employee-owned shares were surrendered to satisfy the withholding taxes due upon vesting of restricted stock. The value of the surrendered stock was $65,615. In December 2009 we retired all our treasury stock and this stock is no longer considered treasury stock, but returned to authorized and unissued stock. At June 30, 2010 and June 30, 2009, the total value of our treasury stock was zero.
Income Taxes
We account for income taxes under an asset and liability approach. This process involves calculating the temporary and permanent differences between the carrying amounts of the assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The temporary differences result in deferred tax assets and liabilities, which would be recorded on our Consolidated Balance Sheet in accordance with ASC Topic 740, (SFAS No. 109, Accounting for Income Taxes), which established financial accounting and reporting standards for the effect of income taxes. We must assess the likelihood that its deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. Changes in our valuation allowance in a period are recorded through the income tax provision on the consolidated statement of operations.
We have adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance ASC Topic 740, (SFAS No. 109, Accounting for Income Taxes) and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As a result of the implementation of FIN 48, we recognized no material adjustment in the liability for unrecognized income tax benefits. At the adoption date of January 1, 2007, we had $176,639 of unrecognized tax benefits, none of which would affect its effective tax rate if recognized.
Fair Value Measurements
We follow ASC Topic 820 and 825, (SFAS 157, Fair Value Measurements) which clarify a number of considerations with respect to fair value measurement objectives for financial reporting and expand disclosures about the use of fair value measurements. The guidance regarding fair value measurements is intended to increase consistency and comparability among fair value estimates used in financial reporting. The disclosure requirements are intended to provide users of financial statements with the ability to assess the reliability of an entity's fair value measurements.
Definition of Fair Value
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and, therefore, represents an exit price, not an entry price. We hold or have held fixed maturities, equity securities, derivatives, and embedded derivatives, which are carried at fair value.
The degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information. The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows and applies to the secured note effective September 1, 2009:
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Level 1-Valuations based on quoted prices in active markets for identical assets. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
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Level 2-Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, directly or indirectly. Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
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Level 3-Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
Debt Financing - Fair Value of Repurchased Shares
We applied ASC Topics 820 and 825 (SFAS 157, Fair Value Measurements) to assess the fair value of 2,391,906 shares of common stock that we repurchased during the first quarter of fiscal 2010. On September 1, 2009, we obtained $4,000,000 in debt financing, and pursuant to the terms of the loan agreement, we were required to use a portion of the loan proceeds to repurchase 2,391,906 shares of common stock at an aggregate price of $1,674,336 ($0.70 per share). At the time we negotiated the term sheet with Mr. Giles, the closing trading price for our common stock ranged from $0.60 to $0.79 per share, and on September 1, 2009 (the closing date of the loan transaction), the closing trading price of our common stock was $0.95.
We recorded the repurchased shares on our balance sheet as treasury stock having a fair value of $1,468,609 ($0.614 per share). We determined fair value using a bid-ask regression model which uses Level 2 inputs for the determination of fair value, which take into account the quoted market price of the common stock and historic trading volumes. We recorded $205,725 on our balance sheet as a discount on the secured note, representing the difference between the fair value of the common stock repurchased ($1,468,609) and the repurchase price ($1,674,336). The discount on the Note is being amortized as interest expense using the effective interest method over the 48-month term of the Note. At June 30, 2010, the unamortized discount on the Note was approximately $143,000.
Stock-Based Compensation
We use the Black-Scholes option-pricing model to estimate the calculated value of our share-based payments. Stock options are valued as of the date of grant. The volatility assumption used in the Black-Scholes formula is based on the volatility of our common stock. The following assumptions were used to compute the fair value of option grants for the fiscal years ended June 30:
We granted 351,700 equity-based payment awards under our incentive compensation plan for the fiscal year ended June 30, 2010, compared to 192,000 equity-based payment awards for the fiscal year ended June 30, 2009. We issued 293,000 incentive-based restricted shares for the fiscal year ended June 30, 2010, compared to 179,392 incentive-based restricted shares for the fiscal year ended June 30, 2009. The Board of Directors approved the extension of the restriction period for restricted shares from three years to five years at the March 29, 2010 meeting, subject to approval by each restricted stockholder.
Revenue Recognition
We recognize revenue in the period that the related services are performed and collectability is reasonably assured. Currently, we derive substantially all of our revenues from laboratory services. Service contracts generally take the form of fixed-price contracts. Under fixed-price contracts, revenue is recognized as services are performed, with performance generally assessed using output measures, such as units-of-work performed to date as compared to the total units-of-work contracted. Changes in the scope of work generally result in a renegotiation of contract pricing terms and/or a contract amendment. Renegotiated amounts are not included in net revenues until earned, and realization is assured. Advance payments on service contracts are treated as a deposit and applied to periodic billing during the contract period. Setup and administrative fees are billed upon contract approval. Revenues from setup and administrative fees are amortized over the life of the contract. Historically, costs are not deferred in anticipation of work on contracts after they are awarded, but instead are expensed as incurred. All out-of-pocket costs are included in expenses.
Net Income (Loss) Per Share
Basic income (loss) per share is based upon the weighted average number of our outstanding common shares. Diluted income (loss) per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options and warrants using the “treasury stock” method. All per share calculations exclude treasury shares.
For the year ended June 30, 2010, we did not include common stock equivalents related to our (i) in-the-money, vested options and (ii) in-the-money warrants in the computation of diluted (loss) per share because we had net losses in this period and the effect would be anti-dilutive. In contrast, because we had net income for the year ended June 30, 2009, we did include common stock equivalents related to our (i) in-the-money, vested options and (ii) in-the-money warrants in our computation of diluted earnings per share. As of June 30, 2009, our common stock equivalents included: (i) in-the-money, vested options to purchase 233,167 shares of common stock and (ii) in-the-money warrants to purchase 394,105 shares of common stock.
Components of basic and diluted income (loss) per share were as follows for the years ended June 30, 2010 and 2009:
Comprehensive Income
We have adopted US GAAP standards for reporting comprehensive income and its components in the financial statements. Comprehensive income consists of net income and other gains and losses affecting stockholders’ equity that, under generally accepted accounting principles are excluded from net income. For the year ended June 30, 2010 and 2009, our comprehensive income (loss) equaled our net income (loss). Accordingly, a statement of comprehensive income (loss) is not presented.
Use of Estimates
In preparing financial statements in conformity with U.S. GAAP, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the 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.
New Accounting Pronouncements
In December 2009, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update, Transfers and Servicing (Topic 860) Accounting for Transfers of Financial Assets. The amendments in this update to the Accounting Standards Codification are the result of FASB Statement No. 166, Accounting for Transfers of Financial Assets. We believe adoption of this new guidance will not have a material impact on our financial statements.
In December 2009, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update for improvements to financial reporting by enterprises involved with Variable Interest Entities. The new guidance includes revised evaluations of whether entities represent variable interest entities and additional disclosures for variable interests. We believe adoption of this new guidance will not have a material impact on our financial statements.
In January 2010, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update, Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures about Fair Value Measurements. The Update would affect all entities that are required to make disclosures about recurring and nonrecurring fair value measurements. The Board concluded that users will benefit from improved disclosures in this Update and that the benefits of the increased transparency in financial reporting will outweigh the costs of complying with the new requirements. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 31, 2010, and for interim periods within those fiscal years. We are currently evaluating the impact this update will have on our consolidated financial statements.
In January 2010, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update to address implementation issues related to the changes in ownership provisions in the Consolidation-Overall Subtopic (Subtopic 810-10) of the FASB Accounting Standards Codification™, originally issued as FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements. Subtopic 810-10 establishes the accounting and reporting guidance for noncontrolling interests and changes in ownership interests of a subsidiary. The amendments in this update are effective beginning in the period that an entity adopts Statement 160 (now included in Subtopic 810-10). If an entity has previously adopted Statement 160 as of the date of the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the interim or annual reporting period ending on or after December 31, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted 160. We are currently evaluating the impact this update will have on our consolidated financial statements.
In April 2010, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update, Receivables (Topic 310): Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset-a consensus of the FASB Emerging Issues Task Force. The amendments in this Update affect any entity that acquires loans subject to Subtopic 310-30, that accounts for some or all of those loans within pools, and that subsequently modifies one or more of those loans after acquisition. We believe adoption of this new guidance will not have a material impact on our financial statements.
In July 2010, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This Update is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. We are currently evaluating the impact this update will have on our consolidated financial statements.
Other recent accounting pronouncements issued by the FASB, the American Institute of Certified Public Accountants ("AICPA"), and the SEC did not or are not believed by management to have a material impact on our present condensed consolidated financial statements.
3. Concentration of Credit Risk
Our largest client in fiscal 2010 and 2009 individually accounted for approximately 27% of our total revenues. This was the same client in each fiscal period. Component clients included in the largest client calculation may vary from period to period. As of June 30, 2010 and 2009, respectively, approximately 38% and 41% of our accounts receivable balance were from the two largest clients at that time. One of these clients was different.
The majority of our clients are pharmaceutical companies, many of which are on the list of Fortune 500 companies. For our revenue calculations, we aggregate revenues we receive from several divisions within one pharmaceutical company client as a single client. For the year ended June 30, 2010, 37% of our revenue was derived from Fortune 500 clients compared to 33% for the year ended June 30, 2009. We believe that our exposure to concentration of credit risk is very low considering the financial strength of our clients.
We maintain cash in three insured commercial accounts and one uninsured investment account at major financial institutions. Although the financial institutions are considered creditworthy and have not experienced any losses on client deposits, our cash balance exceeded Federal Deposit Insurance Corporation (FDIC) limits by $1,361,155 at June 30, 2010 and by $865,406 at June 30, 2009. FDIC limits were increased from $100,000 per insured account to $250,000 per insured account effective October 10, 2008. The new FDIC limits expire on December 31, 2013.
Our accounts are non-interest bearing and would have been covered under FDIC’s Transaction Account Guarantee Program which provided unlimited coverage. However, both of our banks opted out of this program effective January 1, 2010.
4. Prepaid Expenses and Other Assets
Prepaid expenses consisted of the following at June 30:
5. Property and Equipment
Property and equipment consisted of the following at June 30:
At June 30, 2010 and 2009, respectively, these amounts included assets under capital leases of $1,309,311 and $553,621, and related accumulated amortization of $473,783 and $380,716. Depreciation expense for the fiscal years ended June 30, 2010 and 2009 was $343,716 and $263,756, respectively.
6. Accrued Liabilities
Accrued liabilities consisted of the following at June 30:
7. Capital Lease Obligations
We lease laboratory and other equipment under capital lease arrangements. The obligations under capital leases have interest rates ranging from approximately 6.5% to 19.35% and mature at various dates through 2015. Annual future minimum lease payments for fiscal years subsequent to June 30, 2010 are as follows:
8. Notes Payable
Secured Note
Effective September 1, 2009, we obtained $4,000,000 in debt financing from a member of our Board of Directors, Mr. Terry Giles. Pursuant to the terms of the loan agreement, we were required to use a portion of the loan proceeds to repurchase 2,391,906 shares of common stock from Mr. Giles and certain other parties designated by Mr. Giles at a price of $0.70 per share or an aggregate price of $1,674,336. At the time we negotiated the term sheet with Mr. Giles, the closing trading price for our common stock ranged from $0.60 to $0.79 per share, and on September 1, 2009 (the closing date of the loan transaction), the closing trading price of our common stock was $0.95. Concurrent with the financing transaction, Mr. Giles resigned from the Board of Directors. We issued a secured note payable bearing interest at 12% per annum, due on August 31, 2013. We received net loan proceeds of $2,325,664, after payment for stock repurchase for $1,674,336.
In connection with the Note, the terms were:
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Interest: The Note bears interest at 12% per annum.
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Monthly payments: The loan is due and payable over 48 months, with the first 8 months being interest only ($40,000 per month) beginning September 30, 2009, and thereafter (beginning May 31, 2010) 40 monthly payments of principal and interest ($121,822 per month).
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Additional Loan Rights: During the first 12 months of the term of the loan, we have the right, in our sole discretion, to obtain an additional $500,000 loan from the lender on the same terms.
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Security: The loan is secured by a security interest in all of our assets. In addition, each of our subsidiaries guaranteed our obligations under the loan and granted a security interest in all of its assets.
We recorded $205,727 on our balance sheet as a discount on the secured note, representing the difference between the fair value of the common stock repurchased ($1,468,609) and the repurchase price ($1,674,336). The discount on the Note is being amortized as interest expense using the effective interest method over the 48-month term of the Note. At June 30, 2010, the unamortized discount on the Note was approximately $143,000.
Summary of Secured Note and Laurus Notes Payable
We had the following other notes payable as of June 30:
The Laurus Notes were paid in full during December 2008. The gain from adjustment of embedded and freestanding derivatives to fair value was approximately $676,000 for the fiscal year ended June 30, 2009. A component of other expense for the year ended June 30, 2009 was approximately $18,000 of amortization of deferred financing costs on the Laurus debt.
Future maturities on long-term debt as of June30, 2010 are as follows:
As of June 30, 2010, the amount of the long-term note payable is stated at contract amount which approximates fair value based on current interest rates.
9. Income Taxes
The income tax expense reconciled to the tax expense computed at the statutory rate was approximately as follows during the years ended June 30:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our net deferred tax assets are approximately as follows at June 30:
Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to the “change in ownership” provision of the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. Reconciliation of the statutory federal income tax to our effective tax rate is as follows:
At June 30, 2010, operating loss carryforwards of approximately $17 million expiring through 2029 are available to offset future taxable income. For financial reporting purposes, a valuation allowance of approximately $6,267,000 has been recognized to offset the deferred tax asset due to the uncertainty of future utilization of net operating loss carryforwards and realization of other deferred tax assets. For the fiscal year ended June 30, 2010, the valuation allowance was increased by approximately $567,000. For the fiscal year ended June 30, 2009, the valuation allowance was decreased by approximately $235,000, respectively.
Internal Revenue Code Section 382 places a limitation on the amount of taxable income that can be offset by carryforwards after a change in control (generally greater than 50% change in ownership). As a result of these provisions, utilization of the NOL and credit carryforwards may be limited.
10. Stock Incentive Plans and Stock Based Compensation
Stock Incentive Plan
Our 1996 Stock Incentive Plan (the “1996 Plan”) provided for the issuance of up to 1,800,000 shares of common stock under this Plan. Options granted under the 1996 Plan may have been either incentive stock options within the meaning of Section 422(b) of the Internal Revenue Code, or nonqualified options. Our 1996 Stock Incentive Plan expired by its terms on July 9, 2006, but outstanding options and awards previously granted under the 1996 Plan continue in accordance with their terms.
Stock Incentive Plan
We have a Stock Incentive Plan (the “2005 Plan”) with 3,000,000 shares of common stock reserved for issuance under this Plan. Options granted under the Plan may be either incentive stock options within the meaning of Section 422(b) of the Internal Revenue Code, or nonqualified options. We may also grant restricted stock awards. The option price of each incentive stock option granted shall not be less than the fair market value of the underlying common stock on the grant date, and will expire no later than ten years following the date of grant. With respect to nonqualified options, the exercise price and term shall be determined at the discretion of the Board. However, the exercise price shall not be less than the fair market value of the underlying common stock on the grant date, and the term will not exceed a period of ten years. The options generally vest over a range of immediately to three years. As of June 30, 2010, 1,145,285 shares of common stock remained available for future grant under the 2005 Plan.
The following is a summary of the activity in the 1996 and 2005 Plans for the year ended June 30, 2010:
As of June 30, 2010, outstanding options had exercise periods which expire over the following time periods:
The weighted average contractual life remaining of options outstanding at June 30, 2010 is approximately 5 years.
The 1996 Plan expired by its terms on July 9, 2006, but outstanding options and awards previously granted under the 1996 Plan continue in accordance with their terms.
Stock Based Compensation
We granted 151,700 equity-based payment awards with an exercise price of $0.60 and 200,000 equity-based payment awards with an exercise price of $0.88 under our incentive compensation plan for the fiscal year ended June 30, 2010, compared to 192,000 equity-based payment awards with an exercise price of $0.41 for the fiscal year ended June 30, 2009. The fair value of options granted during fiscal 2010 was $248,788. The fair value of options granted during fiscal 2009 was $54,374. We issued 293,000 incentive-based restricted shares for the fiscal year ended June 30, 2010 at fair value of $186,300, compared to 179,392 incentive-based restricted shares for the fiscal year ended June 30, 2009 at fair value of $73,551. The Board of Directors approved the extension of the restriction period for incentive-based restricted shares from three years to five years at the March 29, 2010 meeting, subject to approval by each restricted share holder.
Compensation expense for share-based awards for the fiscal years ended June 30, 2010 and 2009 was included in our consolidated statements of operations as follows:
As of June 30, 2010, the total compensation of $199,971 for unvested shares is to be recognized over the next 1.84 years on a weighted average basis.
We did not have any "in the money" options or warrants as of June 30, 2010; therefore the intrinsic value is zero.
11. Stock Purchase Warrants
The following is a summary of the activity in stock warrants for the year ended June 30, 2010:
As of June 30, 2010, outstanding stock warrants had exercise periods which expire over the following time periods:
12. Commitments and Contingencies
Operating Leases
On January 20, 1998, we entered into a non-cancelable operating lease for office facilities and laboratory space. Under the current lease we are responsible for our proportionate share of real estate taxes, insurance and common area maintenance costs. The office lease has been renewed per agreement with the lessor on April 1, 2007, effective November 1, 2007. The current monthly rent under the lease is $21,639, and the monthly rental rate increases approximately three percent on each November 1 for the remainder of the term. The lease term expires October 31, 2012.
On August 1, 2009, we entered into a non-cancelable operating lease for our biomarker services laboratory. Under the current lease we are responsible for our proportionate share of real estate taxes, insurance and common area maintenance costs. The current monthly rent under the lease is $5,595. The lease term is 24 months and expires August 31, 2011.
Rent expense was $324,296 and $306,947 for the years ended June 30, 2010 and 2009, respectively.
Future minimum lease payments are as follows:
Security Interest
In connection with our secured note agreement, we granted to Mr. Giles a security interest in all of our assets. In addition, each of our subsidiaries guaranteed our obligations under the loan and granted a security interest in all of its assets. The loan agreement provides a waiver of security interest in purchases of equipment that may be financed by other means such as leasing.
13. Retirement Plan
We have a 401(k) Plan that was reopened to employees in May 2005. The 401(k) Plan covers all employees over the age of 21 with 1,000 hours of service in a 12-month eligibility computation. We make a contribution equal to one-half of the employee’s contribution up to the maximum of 6%. We can make discretionary contributions as determined by its board of directors, not to exceed the amount permissible under the Internal Revenue Code. We have not made any discretionary contributions since the plan was reopened. For the fiscal year ended June 30, 2010, our matching expense was $96,124 and 401(k) payable balance as of June 30, 2010 was $0.
14. Subsequent Events
On July 1, 2010, we granted 1,439,900 equity-based payment awards under our incentive compensation plan. The fair value of these awards at the grant date was $460,768.
On September 13, 2010, we entered into an amendment of our employment agreement with Ronald R. Helm, our Chief Executive Officer. Under this amendment, to be effective October 1, 2010, we (a) extended his employment agreement for an additional two years, to September 30, 2012, (b) his annual base salary remains at $300,000, and (c) agreed to grant to him stock options for 600,000 shares of common stock on October 1, 2010. The stock options vest monthly over a period of three years from the grant date, and will have an exercise price equal to the closing market price on the grant date.