Item 1. Business Forward-looking Statements
This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, including: our ability to obtain regulatory approvals and complete clinical and pre-market activities needed to launch new products and gain market acceptance of any new products; the impact of competition, including products competitive with our Triage® BNP Tests, from companies with greater capital and resources; the impact of consolidation of major competitors in the market for immunoassay testing; our ability to effectively promote our products, whether directly or through distributors, including our ability to effectively promote our products in the physician office market; the extent to which our products and products under development are successfully developed and gain market acceptance; our ability to successfully expand our business through direct sales in certain European countries; potential contract disputes or patent conflicts; manufacturing inefficiencies, backlog, delays or capacity constraints; the timing of significant orders or the impact of seasonality; regulatory changes, uncertainties or delays; product recalls; dependence on third-party manufacturers and suppliers; changing market conditions and the other risks and uncertainties described under Item 1A, “Risk Factors” and elsewhere in this Annual Report on Form 10-K. Actual results may differ materially from those projected. These forward-looking statements represent our judgment as of the date of the filing of this Annual Report on Form 10-K. We disclaim any intent or obligation to update these forward-looking statements.
Overview
Founded in 1988, Biosite® Incorporated is a global medical diagnostic company utilizing a biotechnology approach to create products for the diagnosis of critical diseases and conditions. Our primary business goal is to leverage our research and development advances and our installed base of existing customers to deliver first-in-class blood tests that provide diagnostic information not readily available to physicians treating acute diseases and conditions. To do this, we focus on validating, and patenting when possible, novel protein biomarkers and panels of biomarkers, manufacturing complex products at appreciable profit margins, conducting strategic clinical studies intended to validate our products’ diagnostic utilities and demonstrate favorable outcomes, and educating healthcare providers on the benefits of our diagnostic tests.
We market immunoassay diagnostics in the areas of cardiovascular disease, drug screening and infectious diseases. Today our principal products are the Triage BNP Tests, which measure B-type natriuretic peptide, a hormone present at elevated levels in patients with heart failure, and the other Triage cardiovascular products, which includes several multimarker panels intended to aid in the diagnosis of various cardiovascular conditions. In 2006, product sales of our cardiovascular products, consisting of our Triage BNP Tests, Triage Cardiac Panel, Triage Profiler Panels, Triage D-Dimer Test, and Triage Stroke Panel, represented 83% of product sales. Furthermore, in 2006 our cardiovascular product line revenues grew 10% on a year-over-year basis.
We have built direct sales forces in the United States and in several countries in Europe and sell directly to distributors in other foreign countries. We also utilize distributors for logistical support and for sales support in certain markets. In the United States, the Fisher HealthCare Division of Thermo Fisher Scientific Company, or Fisher, distributes our products primarily in hospitals and supports our direct sales force, particularly in smaller hospitals and in U.S. physician offices. Sales to Fisher represented 81% and 84% of our product sales in 2006 and 2005, respectively. Historically, our own direct marketing and sales efforts have primarily targeted hospitals, and particularly emergency departments, or EDs, where rapid, accurate diagnosis is important for high quality, cost-effective healthcare. More recently, we also began to directly market our diagnostic products to physician offices, utilizing a small direct sales force and distributors. We believe that in the future our existing or potential products could be used in a variety of healthcare sites for diagnosis, and possibly for pre-emptive detection or monitoring of chronic diseases, such as heart failure.
Our product development goal is to use our expertise in phage display antibody development, high-throughput screening and data mining techniques, non-instrumented microfluidics and fluorescence energy transfer signal detection to produce diagnostic tests incorporating novel blood protein biomarkers or combinations of biomarkers that can provide better diagnostic information than tests currently available on the market. In 2007, we expect to invest substantially in several research and development programs, including:
· The Triage MPO Test utilizing MPO for prognosis of acute coronary syndrome, and the addition of MPO (for prognosis) to the Triage Cardio Profiler
· The Triage Sepsis Panel for prognostic evaluation
· The Triage NGAL Test for prognosis of kidney injury
· Fingerstick application for the Triage BNP Test
· Clinical studies aimed at additional regulatory clearances for the Triage BNP Test
We have been profitable since the third quarter of 1999 and intend to continue building our business with funds generated from our operations. Our financial strategy is aimed at achieving margins and growth rates consistent with proprietary or first-in-class medical diagnostics or devices. During 2006 our revenues were $308.6 million, our operating margin was 19.8% and our net income was $40.0 million. Also during 2006, we repurchased $130.0 million of our common stock. After our stock repurchases and our investment of an additional $24.0 million used for the purchase of property and equipment, we had $64.2 million in cash and marketable securities at December 31, 2006. Cash flow activity during this period included cash generated from operating activities of $75.1 million.
Commercialization
Hospitals
Currently, our products are principally sold to acute care hospitals and are often used on patients presenting to EDs. In the United States, there are approximately 5,100 acute care hospitals, of which approximately 70% use at least one of our products. According to reports published by the American Hospital Association, U.S. hospitals are increasingly challenged in their efforts to meet the needs of their communities. Issues confronting hospitals today include workforce shortages, increases in liability insurance, higher costs associated with care accompanied by lower payments, shortages of critical care capacity and ED overcrowding resulting in patient diversions and related costs. In 2004, one-third of U.S. hospitals lost money overall.
In recent years, rising demand for ED services in the United States has accompanied constrained capacity. While the problem of ED overcrowding and diversion is most evident in urban and teaching hospitals, 50% of all U.S. hospitals reported capacity problems in 2005. According to statistics published by the U.S. Centers for Disease Control and Prevention, between 1994 and 2004, ED visits increased more than 18%, an estimated average of 1.5 million additional visits per year. The greatest increase was among elderly patients, many of whom have chronic medical conditions. In 2004, abdominal pain, chest pain, fever and cough were among the leading patient complaints, accounting for nearly one-fifth of all visits. While the number of ED visits continues to increase, the overall capacity of the nation’s EDs has decreased, with hundreds of emergency departments closing in the past 10 years. The resulting strain on existing EDs has been intensified by a shortage of inpatient beds, which results in backlogs in the ED as patients wait for beds to open so they can be admitted.
In Europe, where our marketing efforts today focus primarily in western countries, the market is characterized by varying concentrations of hospitals among regions, differing reimbursement systems, pressures to reduce length of stay and declines in hospital capacities, which vary from region to region. Similar to the United States, hospitals in Europe are classified into two tiers: teaching hospitals, which are large university-affiliated institutions supported by state-of-the-art technology and thought leaders, and less advanced regional and rural hospitals that often refer more complex cases to top-tier centers. In Europe, however, there are also more sub-specialty facilities that may specialize in treatment for a particular condition. Today, many European hospitals are government-controlled, and spending on healthcare may be affected by the economic situation in the countries where those hospitals are located. Sales to international customers in 2006, 2005 and 2004 totaled $44.6 million, $35.9 million and $26.0 million, respectively.
Given the dynamics of today’s healthcare systems, we believe that significant market potential exists for rapid diagnostics with novel applications that are capable of precise quantitative measurement of single or multiple analytes. We view our medical diagnostic products as a means of improving and advancing medical care by enabling hospital physicians to triage or evaluate patients quickly, accurately and cost-effectively in order to make important medical decisions.
Physician Offices
In 2003, we began to market our products to outpatient physicians, primarily for use in physician office laboratories. In 2006, sales of our products to physician offices were $13.7 million, a 31% increase over 2005. While all of our products are available for use in physician office laboratories, or POLs, to date, our marketing efforts in this segment have focused on the Triage BNP Test, which aids in the diagnosis, assessment and risk stratification of heart failure and the risk assessment of acute coronary syndrome patients. In 2006, sales of the Triage BNP tests contributed 70% of total sales to physician offices. Given the chronic nature of heart failure and risk of advancement to acute stages, we believe physicians would be interested in using the Triage BNP Test for early diagnosis and ongoing assessment and risk stratification.
Among physician offices, immunoassay testing typically occurs in small on-site centralized POLs serving a physician group or clinic, or in large off-site commercial laboratories. POLs typically use small to mid-size laboratory analyzers to perform immunoassay testing. These laboratories are convenient and enable reasonably rapid turnaround of test results, but typically can only be justified for larger group practices and clinics. Furthermore, due to space considerations, test offerings may be limited. Commercial laboratories can provide full service utilizing high volume automated analyzers with broad menus and rapid throughput. However, since tests are performed off-site, delivery of test results may take several days and testing tends to be expensive. Although some blood testing occurs in physician offices, this is usually limited to testing that can be accomplished using simple one-step technology that does not require blood to be drawn from the veins in the office.
Initially, we marketed the Triage BNP Test to approximately 15,000 POL’s licensed to run moderately complex tests and serving physicians seeing heart failure patients. In August 2005, the Triage BNP Test was granted a waiver under the Clinical Laboratory Improvement Amendments of 1988, or CLIA, by the United States Food and Drug Administration, or FDA, substantially expanding healthcare professionals’ access to the 15-minute blood test. Following the grant of the CLIA waiver we expanded our marketing efforts to an additional 6,000, 10,000 and 14,000 cardiology offices, family practices and internal medicine offices, respectively.
Product Overview
Our existing products address cardiovascular diseases, drug overdose and infectious diseases. The following table sets forth information on significant Biosite products commercially available in 2006 in the United States and/or Europe.
(1) The products have received FDA clearance for these applications. Pursuit of new applications would require that we seek additional clearances for the new applications from the FDA.
Triage BNP Tests
The Triage BNP Tests measure BNP, a hormone present at elevated levels in patients with heart failure, a serious condition that can lead to impaired heart pumping action. Elevated levels of BNP have also been shown to be associated with increased risk in acute coronary syndrome patients. Acute coronary syndrome, or ACS, refers to a spectrum of conditions involving chest discomfort or other symptoms caused by lack of oxygen to the heart muscle. Both heart failure and ACS can result in death if treatment is delayed or if the conditions are allowed to advance.
Today, our Triage BNP Tests are primarily sold to hospitals. According to statistics published by the U.S. Centers for Disease Control and Prevention, at least 9 million people visit U.S. hospital EDs with symptoms associated with heart failure and approximately 6 million people visit U.S. hospital EDs with complaints of chest pain, a primary symptom of ACS. Within hospitals we believe the primary use of the Triage BNP Tests is for diagnosis of heart failure. Use of the tests for risk assessment of ACS patients is an emerging application. The tests are not FDA approved for monitoring of hospital inpatients, and although some “off label” usage may occur, we do not promote our test for this application.
We offer two versions of our Triage BNP Test. The first version, launched in 2001, is performed using our Triage Meter, a portable platform that produces a result in about 15 minutes. In 2004, we launched the Triage BNP Test for Beckman Coulter® Immunoassay Systems, which enables our test to be run using any of Beckman Coulter’s automated testing platforms. We believe this arrangement provides our customers with a choice of platforms for BNP testing, thereby enabling flexibility in selecting a BNP test that suits their needs. In 2006, 32% of our BNP product sales resulted from customer purchases of the Triage BNP Test for Beckman Coulter Immunoassay Systems.
Currently, the BNP market in the hospital setting is not perceived to be expanding at a significant rate due to high levels of site penetration and regulatory and educational hurdles slowing the emergence of new applications. Additionally, increased competition, customer conversions to our lower-priced Triage BNP Test for Beckman Coulter Immunoassay Systems and higher price sensitivity on the part of hospital systems and purchasing groups have contributed to price erosion, which is a factor in the slowing of sales growth. We are continuing to explore and research enhancements to our Triage BNP Tests that could improve performance, ease-of-use or differentiation from competitive products.
We also sell the Triage BNP Tests for use by physicians treating outpatients. According to the American Heart Association, in the United States approximately 5 million individuals have been diagnosed with heart failure. Our Triage Meter-based BNP Test was designated as a CLIA-waived product in 2005, meaning that the test can be performed by any healthcare professional. Currently, this product is the only CLIA-waived BNP test available in the United States. We primarily market our Triage Meter-based BNP test to approximately 45,000 physician offices through a direct sales force augmented by distributors. In 2006, sales of our Triage BNP Tests to the physician office market were $9.6 million. We have added and are continuing to add sales and clinical resources aimed at bolstering our marketing and educational efforts in this segment of the market.
We believe that significant validation of the Triage BNP Test in physician offices will be necessary in order to achieve widespread acceptance of this diagnostic test, particularly among family practice and internal medicine physicians, who are unlikely to be familiar with BNP.
Triage Cardiac and Profiler Panels
Chest pain and breathing difficulty are common symptoms of ACS that each year account for millions of visits to U.S. EDs. Information from the 2004 National Hospital Ambulatory Medical Care Survey of U.S. hospitals indicates that in 2004 there were approximately six million ED visits by adults suffering from chest pain. Among chest pain patients, those with heart attack, a critical permutation of ACS, are at greatest risk of serious injury and in need of rapid diagnosis. Patients experiencing breathing difficulty may be suffering from heart failure, pulmonary embolism or silent heart attack, all critical conditions requiring therapeutic intervention.
Due to the complicated nature of most cardiac diseases, we believe that panels of multiple markers will be extremely useful as diagnostic tools for cardiac conditions. In 1998, we received FDA clearance for the Triage Cardiac Panel, which enables physicians to obtain measurements of three cardiac biomarkers that aid in the diagnosis of heart attack. At the time of launch, that product was primarily differentiated from competition by its ability to provide simultaneous measurements of the three biomarkers in about 15 minutes. We believe our customers can obtain the greatest benefit when the test is performed in a location near the emergency room, in order to capitalize on the speed of results. While sales of this product have grown steadily in recent years, the Triage
Cardiac Panel faces substantial competition. Other barriers to gaining market share include a lack of protocols relating to the use of rapid diagnostic tests and a lack of familiarity with the use of multiple biomarkers for the evaluation of patients with suspected heart attack.
In 2003, we commenced marketing of a second-generation cardiac panel, the Triage CardioProfiler Panel, which incorporated the three cardiac markers used on the Triage Cardiac Panel and BNP. Through the addition of BNP, the Triage CardioProfiler Panel is intended to serve as an enhancement to the Triage Cardiac Panel, by enabling the risk stratification of patients with ACS and by allowing physicians to evaluate a patient for heart failure, which has some symptoms common to heart attack.
In 2004, we launched the Triage Profiler Shortness of Breath Panel. This panel includes a biomarker called D-dimer in addition to the biomarkers used on the Triage CardioProfiler Panel. The panel is intended to help a physician evaluate the cause of shortness of breath, a symptom common to a variety of conditions including, but not limited to, heart failure, pulmonary embolism, ACS, pneumonia and asthma.
Drug Overdose Products
Drug abuse plays a significant role in emergency medicine cases, either as a primary cause or as a contributing factor. A diagnostic dilemma confronts physicians when patients present with symptoms that could be either drug related or non-drug related. For instance, a patient brought into an ED in a coma may be under the influence of narcotics or sedatives, thus requiring a certain type of treatment or intervention. Conversely, the same patient may have had a stroke or suffered some form of trauma requiring a completely different type of care. The ability to obtain a differential diagnosis in a timely manner greatly aids the course of treatment in patients such as these.
We introduced the first Triage Drugs of Abuse Panel in 1992 and launched the second-generation Triage TOX Drug Screen in January 2002. The Triage Drugs of Abuse Panels and Triage TOX Drug Screen are rapid, qualitative urine screens that analyze a single test sample for different illicit and prescription drugs or drug classes, and provide results in approximately 10 to 15 minutes. The Triage Drugs of Abuse Panels are configured to test for various combinations of drugs and provide a visual result in about ten minutes. The Triage TOX Drug Screen is a test device used for the simultaneous detection of parent compound and/or the major metabolites of up to eight drug classes (nine unique assays) in urine. A qualitative (positive or negative) result is available in about 15 minutes.
Sales and Distribution
We maintain direct sales forces in the United States and in key countries in Europe and sell to distributors in other markets. We also utilize distributors for logistical support and for sales support in certain markets. A field-based network of clinically experienced individuals supports the sales effort in all of our direct markets by providing pre- and post- sale education and training. To date our marketing and sales efforts have primarily targeted hospitals, particularly EDs, where rapid, accurate diagnosis is important for high-quality, cost-effective healthcare. In 2003, we also began to market our diagnostic products to physician offices, utilizing a small direct sales force and distributors.
In the United States, we utilize a direct sales team that focuses on hospitals with more than 200 beds and on smaller hospitals that are high volume users of our products. Fisher distributes our products primarily in hospitals in the United States and supports our direct sales force, particularly in smaller hospitals and in U.S. physician offices. We have a distribution agreement with Fisher that extends through December 31, 2008. Sales to Fisher represented 81% and 84% of our product sales in 2006 and 2005, respectively.
To market our products to U.S. physician offices we utilize a small direct sales team. We also use several distributors in this market, including Physician Sales & Services, or PSS, Fisher, and Henry Schein, Inc., or Henry Schein. We may also engage other distributors and/or supplement our own small direct sales force for this market in the future.
In international markets, we have established direct selling efforts in several European countries and utilize a network of country-specific and regional distributors in other areas. In the future, we plan to expand our existing direct sales and clinical resources and may transition to direct sales and distribution of our products in additional countries. Sales to international customers in 2006, 2005 and 2004 totaled $44.6 million, $35.9 million and $26.0 million, respectively.
Because our products are designed to improve the practice of medicine, rather than merely reduce the cost of testing, we invest substantially in relevant education for healthcare clinicians using our diagnostic products. While diagnostic companies traditionally market their products solely to clinical laboratories, we believe we generate demand for our products among laboratory clinicians, physicians and hospital administrators by demonstrating the medical and economic advantages of our diagnostic products. Supporting our worldwide sales team is a field-based network that includes clinically experienced individuals providing pre- and post- sale education and training and customer and technical support resources to assist with ongoing utilization of our products. As of December 31, 2006, our worldwide sales team and our supporting in-house and field-based network consisted of 115 and 80 representatives, respectively.
Product Development and Selected Potential Products
Our product development goal is to use our expertise in high-throughput screening and data mining techniques to produce diagnostic tests incorporating novel blood protein biomarkers or combinations of biomarkers that can provide better diagnostic information than tests currently available on the market. Currently, our key development efforts are focused on the areas of cardiovascular diseases and conditions, sepsis and kidney injury.
Our product development process consists primarily of research conducted through our Biosite Discovery Program, feasibility research, assay development and clinical studies that enable us to study biomarkers and their potential applications post-discovery. These studies are also used to set product performance and validate product utility. In 2007, we expect a significant increase in the number, size, duration and complexity of our clinical studies.
Discovery
The recent upsurge in the understanding and utility of human biomarkers has been the catalyst for our discovery efforts. These biomarkers include proteins, peptides, enzymes, hormones and other blood-borne molecules that are the biologically active components of normal and diseased physiology. In most diseases, tissue damage and biological response mechanisms change the blood levels of analytes enabling them to be used as diagnostic “disease biomarkers.” Most disease biomarkers currently in clinical use signal disease when their concentrations rise above a defined normal cut-off point. For example, above-normal concentrations of the following biomarkers result in a positive disease diagnosis:
Given the low returns to date, biomarker discovery has historically been viewed as an expensive, time-consuming and risky undertaking for commercial enterprises. As a result, large diagnostic companies generally look to academic researchers for new biomarker validation or rely on clinically proven biomarkers in developing testing menus. We have developed our own internal program, Biosite Discovery, focused on identifying novel proteins or combinations of proteins that function as disease biomarkers and have high diagnostic utility.
We focus on mining the human proteome for diagnostic biomarkers for which we can obtain exclusive or semi-exclusive rights to develop, market and sell in major commercial markets. We are discovering useful correlations between blood-borne proteins and the diagnostic questions most frequently and urgently asked by caregivers. Key to Biosite Discovery is our proprietary Omniclonal® phage display antibody development technology, which enables the rapid and cost-efficient development of immunoassays that can be used to evaluate up to several hundred potential disease biomarkers each year.
Our Biosite Discovery program encompasses a three-step process:
1. Through a variety of collaborations, we collect patient blood samples related to disease states in which we are interested. These samples include disease-specific samples, samples from patients with conditions that mimic the targeted disease, as well as samples from a normal, disease-free population. We seek to establish comprehensive sample banks, accumulating thousands of samples. Sample collection can be time intensive and subject to fluctuations in timing, and, as a result, our ability to establish relationships and collaborations with reliable sources of samples is essential.
2. Once samples are available, we use them for testing as we conduct “marker mining” to find biomarkers with high diagnostic utility for a targeted disease. To do this, we use immunoassays, which require tightly binding, or high-affinity, antibodies to test potential biomarkers against our sample bank. Our ability to efficiently develop large quantities of high-affinity antibodies for these research immunoassays allows us to screen large numbers of biomarker targets in our efforts to identify those most suitable for a diagnostic product.
3. When data for potential biomarkers is available, we define the priority of the biomarkers in terms of their unique value to the specific product that we are developing. This enables us to determine the optimal biomarkers for a product. Once this decision is made, the product proceeds to development.
We believe that our Biosite Discovery model is significantly different from discovery methods employed by other companies in the diagnostics industry and we view this as a competitive advantage. Some of our differentiating qualities include:
Rapid Antibody Development: We believe we enjoy a unique position in the area of phage display antibody development. We believe that our internal antibody development capabilities allow rapid identification and development of antibodies with optimal specificity, affinity and stability characteristics. Using our proprietary Omniclonal phage display antibody development technology, we can quickly create high quality antibody libraries in weeks. Following evaluation for clinical relevance, the useful antibodies can be economically produced in large reproducible quantities.
High Throughput Capacity: Because we utilize a highly efficient antibody technology and have automated the most significant liquid handling steps, we believe we currently have a high throughput capacity to develop high-affinity antibodies. With this high throughput capacity, we are able to generate antibodies to a substantial number of targets in a cost-efficient manner. This permits us to take on significant discovery endeavors to identify, evaluate and develop novel diagnostics.
Target Validation Approach: To gain access to large numbers of protein targets and clinically documented samples that can be studied for association with selected diseases, we collaborate with commercial companies and clinical institutions. We believe we have expertise in establishing sample banks that can be used for validation purposes. Combined with our ability to efficiently develop assays used to study biomarker targets, this enables us to study high numbers of proteins, thereby increasing the possibility of validating high-potential biomarkers. For instance, in developing our potential sepsis test, we studied more than 150 proteins and peptides, as well as numerous combinations of these using approximately 1,000 patient samples. We believe that most other diagnostic companies would have to outsource this type of work and rely on slower and more costly methods in order to replicate our processes.
Development
Historically, we have made significant investments in research and development, exceeding traditional diagnostic industry standards. These investments have yielded several proprietary advances in the biological and physical sciences that serve as the basis for our diagnostic biomarker discovery platform and make practical the development and manufacture of rapid, accurate and cost-effective diagnostics. Our products integrate our expertise in several core scientific and engineering disciplines, including antibody development and engineering, analyte cloning and synthesis, development of highly sensitive fluorescence energy transfer dyes, signaling chemistry, microcapillary protein array technology and sample handling. By combining research capabilities in each of these areas, we create novel single and multi-analyte diagnostics that overcome the limitations of traditional diagnostic technologies and seek to address the significant unmet need for effective, real-time diagnostic information.
Antibody Development and Engineering: For more than a decade, we have been in-licensing and developing proprietary antibody development and production technology based on phage display, which creates genetically engineered, antibody-producing microorganisms. Phage display is a considerably faster and less labor intensive process than traditional means of antibody development, such as hybridoma technology. Phage display technology enables the high throughput generation of custom Omniclonal antibody libraries containing gene encoded antibodies specific to a selected target analyte. Omniclonal antibodies produced from such libraries can contain thousands of different antibodies that bind to a target analyte with high-affinity, which refers to an antibody’s ability to bind tightly to targets and is a highly desired attribute. Monoclonal antibody candidates can be rapidly selected from an Omniclonal antibody library and produced in quantities sufficient for product development. During the course of product development, unexpected antibody cross reactivities often require additional selection of antibodies to improve the assay specificity. Unlike hybridoma technology, Omniclonal antibody libraries can rapidly provide
additional antibody candidates in these circumstances.
The intellectual property required for commercial development of phage display antibodies is fragmented, because important parts of the process were discovered in many laboratories around the world. As a consequence there are many issued patents that cover individual steps between antibody discovery and commercial production. Since the early years of our research programs, we have been inventing our own processes relating to the commercialization of phage display of antibodies, as well as successfully negotiating and purchasing licenses to the critical pieces of technology. In effect, we believe that our own inventions and know-how in this field combined with our portfolio of licenses, many of which are non-exclusive, provide us with an important competitive advantage.
Analyte Cloning and Synthesis: Our molecular biology capabilities include the cloning and identification of specific proteins useful in the development of immunoassays. We developed proprietary expression vectors that enable the production and purification of these proteins for the development of antibodies and for use as calibrators and controls in our immunoassay products. In addition, our considerable expertise in synthetic organic chemistry allows the synthesis of targets and useful derivatives. We develop products where the targeted analyte is small (i.e., haptens, such as drugs) or large (i.e., proteins, such as cardiac enzymes). We believe that the ability to develop, stabilize and manufacture the target analyte or its analogues is key to the development of highly accurate immunoassays.
Highly Sensitive Fluorescence Energy Transfer Dyes: Immunoassays require the attachment of a detectable label to an antibody or target analyte. We developed a variety of labels for use in our products. For our qualitative products, a visual label that produces color is attached to antibodies or analytes through either non-covalent or covalent chemical methods to provide yes/no results. For our Triage Meter platform products, we developed novel fluorescent dyes that are usable with complex biological samples and stable for the dating period of the product.
Microcapillary/Protein Array Technology: We developed proprietary technology to design, develop and manufacture protein arrays containing microcapillaries to control the flow of fluids in immunoassay processes. Our qualitative testing device format uses microcapillaries to draw fluids across immobilized antibody zones for the detection of specific substances. Our quantitative testing device format moves fluids through the microcapillaries in a controlled manner. We also developed the engineering capability to design unique microcapillary structures in plastic parts. Recently, we initiated an internal program to fabricate these parts in commercial scale quantities using injection molding processes.
Sample Handling: We developed proprietary technology relating to sample handling and preparation, including technology that allows whole-blood to be passively separated into its plasma component or to be passively lysed to release the target analyte. We also developed technologies for the handling of stool samples that concentrate and purify the target analytes or organisms from solid stool materials. In addition, we developed technologies that can be used to assay urine samples.
The MultiMarker Index™ Value: Because many acute diseases and conditions, such as chest pain, stroke, sepsis and abdominal pain, are complex and have multiple causes, we are focusing a considerable portion of our development efforts on multimarker test panels. Through Biosite Discovery, we believe we can select the optimal biomarkers for a targeted condition. Our research has shown that individual measurements of biomarkers may not always provide the most accurate result. Therefore, we have developed a proprietary process for reducing multiple biomarker measurements to a single MultiMarker Index Value, or MMX Value, that we believe is more easily interpreted and, for many indications, is more accurate than single biomarker measurements in the clinical setting for diagnosis and prognosis.
The MMX Value uses a proprietary automated algorithm to generate a single quantitative value from multiple biomarkers. To validate each MMX Value algorithm, we research a large number of protein targets that are potentially relevant to a disease. We then measure blood levels for all of these proteins in a large library of patient samples for which the ultimate disease diagnoses or prognoses are known. Next, we empirically determine which protein biomarkers provide diagnostic information about the disease and select for commercial development the panel of protein biomarkers that delivers the relevant information.
We believe that our novel approach to discovering and developing new multimarker diagnostic products for unmet applications will provide us with the best opportunity to establish and maintain broad patent protection, which may in turn support a favorable market position for our products.
Clinical Studies
An important component of our product development strategy is to validate the clinical usefulness of our new products. Historically, most new products in the diagnostics arena measured biomarkers or analytes for which clinical validity was already established. Consequently, the pre-market validation process for these tests usually focused on showing that the new product was substantially equivalent in clinical performance with other similar diagnostic products already on the market. Many potential Biosite products lack pre-existing diagnostic models and we may therefore be required to demonstrate safety and effectiveness to regulatory agencies, as well as clinical value to medical thought leaders and others.
To this end, we have developed organizational and institutional relationships necessary to sponsor large clinical studies with the goal of obtaining data to validate the diagnostic indications for uses that we wish to pursue for our products. Once our business development, marketing and research and development, or R&D, groups define new product opportunities and an assay for the potential product is developed, our clinical group, in conjunction with our R&D and regulatory groups, write protocols for clinical studies to optimize and test the validity of the potential new product. We use the terms “training” and “validation” to describe the stages of our clinical studies.
The objective of the training study is to define or revise potential biomarker panels, establish assay cut-offs and, if applicable, set the MMX Value algorithm believed to best define the diagnosis or prognosis of the selected disease or condition. In some cases this data may be used in obtaining CE marking for products to be sold within the European Union. The training study protocol is also used to define the protocol for the subsequent validation study, which is the study performed to generate clinical utility data and to validate the safety and the effectiveness of the product. The goal is to use the results of the validation study to support an FDA submission. Under certain conditions, we may also conduct a pilot study prior to the clinical training study. The goal of the pilot study would typically be to gain data to aid in the refinement of the clinical training study protocol.
The time duration for each of these study phases will be a function of the intended use, prevalence rate of disease or condition, enrollment rate, number of patients required and the number of clinical sites. Most of our validation studies will be multi-center studies and will typically involve between about 500 and 1,000 patients. While our clinical trial process adds considerable time and expense to our development timelines, we believe it provides us with important competitive advantages and, most importantly, can help improve patient care.
Once a product receives regulatory approval and is launched, we also perform large and small scale post-market evaluation studies to demonstrate that our products favorably affect outcomes or provide clinical value to the diagnostic process.
Key Potential Products
The following table presents certain products under development and presents their status as of February 22, 2007.
Triage MPO Test: Myeloperoxidase, or MPO, a biomarker of inflammation of the vasculature, has been found to be elevated in patients with an acute risk of near-term cardiac events. MPO also appears to be an indicator of unstable atherosclerotic plaque and has been shown to elevate earlier than current markers of cardiac cell death. Given its attributes, MPO is believed to be useful as an aid in the early diagnosis of myocardial infarction and could signal risk for heart disease or heart attack in patients with chest pain or ACS. We licensed certain diagnostic rights to MPO in 2004 under an agreement with The Cleveland Clinic Foundation and Prognostix, Inc.
In December 2005, we submitted a Premarket Notification 510(k) to the FDA seeking clearance for the Triage MPO Test and the Triage Cardio Profiler Panel with MPO. In January 2007, we reported that we would allow that
submission to expire after we were unable to resolve questions concerning the inability to pool data among four clinical sample banks used in support of the submission. We are currently underway with studies aimed at providing data intended to support a submission and expect to file a new Premarket Notification 510(k) submission for the prognostic use of MPO within the next several months. In addition, we plan to seek CE marking for the Triage MPO Test, allowing us to market the product in the European Union.
Triage Sepsis Panel: In general, sepsis is a complex syndrome resulting in an inflammatory reaction initiated by microorganisms, including bacteria, viruses and fungi, which can cause widespread damage to the blood vessels leading to circulatory shock, organ failure, gangrene of extremities and death. In the United States, each year approximately 750,000 patients develop sepsis and the aging population is accelerating the prevalence of the disease. Overall mortality of patients developing sepsis ranges from 30% to 60%. Total annual costs for sepsis exceed $16 billion in the United States with the average hospital cost per adult case estimated to be approximately $22,000.
The complications associated with sepsis can advance quickly, and diagnosis is complicated by a lack of effective tests for the condition. We have completed development of a panel of three biomarkers that we believe will be useful to physicians attempting to evaluate risk in patients with sepsis. We expect to commence a multi-center validation study in the second quarter of 2007, and plan to seek CE marking for the product later in the year.
We are also evaluating other potential products in the category of sepsis, including biomarker targets that may be useful in the diagnosis of septic patients. We have collected approximately 4,000 patient samples that are useful for our study of sepsis.
Triage NGAL Test: Neutrophil gelatinase-associated lipocalin, or NGAL, is a protein found in low quantities in the normal kidney and found at up-regulated levels following acute kidney injury, which can lead to renal failure. Studies have shown that 25% of adults in the intensive care unit will develop acute renal failure. The mortality rates associated with dialysis-dependent patients are 40% to 70%, and acute renal failure is associated with various high cost medical problems, treatments and procedures. Consequently, there is a medical need to make an early assessment of the risk for renal failure in patients at risk for kidney injury. Currently, physicians generally use creatinine, which is only a functional marker, as an indicator that an injury to the kidney has taken place. Although creatinine is widely used by the medical community, its limitations are also widely acknowledged. The use of creatinine does not enable effective preventative treatment to be provided because it is elevated only after renal function is impaired.
We obtained an exclusive license to NGAL for use with blood samples, from the Cincinnati Children’s Research Foundation and Columbia University in 2005. Studies in children have suggested that NGAL may be an early biomarker that can be used to evaluate the risk associated with kidney function. Because NGAL has not been studied extensively in adults, we will need to conduct further investigational studies commencing in the first quarter of 2007, prior to starting the clinical validation study. We believe there is a compelling business opportunity for a rapid and accurate test that can aid in the prognosis of patients at risk for developing kidney injury. Optimally, such a test would provide information related to potential kidney injury 48-72 hours prior to a rise in creatinine.
Triage Cardio Profiler Panel with the MMX Value: We currently market the Triage CardioProfiler Panel, a panel of four biomarkers, which is intended to aid physicians who are evaluating patients with chest pain. We expect to expand the panel to five biomarkers upon clearance of our MPO assay and also expect to incorporate the MMX Value, which would analyze information from all five biomarkers and present a single composite index result. We believe that the MMX Value can meaningfully increase the clinical utility beyond that which can be achieved by measuring individual levels of the biomarkers on the panel.
We anticipate commencing a validation study later this year that, in part, is intended to compile data needed to support an FDA submission for a version of the Triage CardioProfiler that incorporates the MMX Value. We also plan to seek CE marking for the product allowing us to enter the European Union market.
Competition
The market for our products is intensely competitive. Our competitors include:
· manufacturers of laboratory-based tests and analyzers;
· clinical reference laboratories; and
· other rapid diagnostic product manufacturers.
Currently, the majority of diagnostic immunoassays utilized by physicians and other healthcare providers are performed by independent clinical reference laboratories and hospital-based laboratories using automated analyzers. We expect that companies offering automated laboratory analyzers will compete vigorously to maintain their dominance of the testing market. Although we now offer our Triage BNP Test for use on Beckman Coulter Immunoassay Systems, our other products are not currently designed for automated batch testing.
Our products’ competitive positions may be based, among other things, on product performance, accuracy, convenience, cost-effectiveness and the strength of our intellectual property. In addition, certain competitors may have more favorable competitive positions than we do in markets outside of the United States.
Certain of our products face significant competition from products marketed by large diagnostic companies that have greater resources than we do. Companies with a significant presence in the diagnostic market, such as:
· Abbott Laboratories;
· Siemens AG;
· Beckman Coulter;
· Dade Behring;
· Johnson & Johnson; and
· Roche Diagnostics
have developed or are developing diagnostics and/or testing systems that do or will compete with our products.
All of the companies listed above that have a significant presence in the diagnostic market have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than us. Moreover, these competitors offer broader product lines and have greater name recognition than us, and offer discounts as a competitive tactic. We may also face competition from smaller companies that are developing new or alternative technologies for point-of-care immunoassay diagnostic products. In addition, we face competition on certain specific product lines from other companies. For instance, our Triage Drugs of Abuse Panel and Triage TOX Drug Screen face significant competition from MEDTOX Scientific and ACON Laboratories. Also, our Triage D-Dimer Test faces significant competition from bioMerieux.
Importantly, the market for immunoassay-based diagnostic testing is rapidly changing as a result of recent consolidation in the industry. Within the past 12 months, Bayer Diagnostics and Diagnostic Products Corp. were both acquired by Siemens AG. In addition, in January 2007, General Electric Corporation, or GE, announced that it entered into a definitive agreement to purchase the laboratory diagnostics business of Abbott Laboratories, including Abbott’s i-STAT product line. Both Siemens and GE have significant existing businesses in related markets for healthcare equipment and services, such as diagnostic imaging. At this time, it is unclear how these acquisitions will impact the competitive landscape for our products or for hospital diagnostic testing generally.
Furthermore, we believe some of our current competitors as well as other currently non-competitive companies are actively engaged in research in areas where we are also performing product development. The resulting products from these companies may directly compete with our potential products or may address other areas of diagnostic evaluation.
The competitive markets for our potential products may be dependent on timing of entries into the markets. Early entry may provide a company with an advantage in gaining product acceptance contributing to the product’s eventual success in the market. Therefore, speed in development and in achieving clinical study and regulatory success may provide an advantage.
The following table presents potential and expected competition relevant to key products under development.
Employees
As of December 31, 2006, we employed 1,036 regular full-time or part-time individuals. Of these, 47 held Ph.D.s and 110 held other advanced degrees. None of our employees are covered by a collective bargaining agreement. We believe that we maintain good relations with our employees.
Research and Development
We have increased our investments in research and development in each of the last three years. As of December 31, 2006, we employed 233 employees in research and development, including 33 Ph.D.s. Our research and development organization is dedicated to the study of novel disease biomarkers or combinations of disease biomarkers, the development of new technologies that can be applied to future products and the development of new products compatible with our existing platform technologies. We also have research staff dedicated to the development and production of antibodies through a variety of techniques. Recombinant techniques are used to express proteins for use as diagnostic markers. Our staffs of chemists and biochemists synthesize drug targets and compounds for diagnostic use and seek to perfect techniques for coupling these compounds to biological reagents such as antibodies or labels when necessary. We developed a proprietary process utilizing phage display antibody technology that enables the selection and production of antibodies more rapidly and efficiently than is possible using hybridoma technology. Our engineering staff is involved in the design and development of new diagnostic device technologies as well as the processes for their fabrication and interaction with biological and chemical reagents. Our product development group completes final optimization of assays and our clinical, medical and regulatory affairs group oversees all in-house clinical studies and coordinates external clinical studies of our products and prepares applications for worldwide product registrations and licensure.
Manufacturing
As of December 31, 2006, we had 419 employees, and approximately 143 temporary employees, in manufacturing involved in reagent production, device assembly, engineering, quality assurance/quality control and materials management.
Except for the Triage BNP Test for the Beckman Coulter Immunoassay Systems and the Triage Meter, all of our products are manufactured at our facility in San Diego, California. We have contracted with Beckman Coulter, Inc., which has a manufacturing plant located in Minnesota, to manufacture the Triage BNP Test for Beckman Coulter Immunoassay Systems. The Triage Meter is manufactured by LRE Technology Partner GmbH, or LRE, which is located in Germany. We developed most of the antibodies used in the manufacture of our products, and in most cases we own or license the relevant cell lines. In addition, we maintain our own in-house antibody production capability. All other raw materials required to manufacture our products are obtained from outside suppliers.
We invest in the design and development of manufacturing systems and technologies that can produce a high quality product using controlled, cost-effective manufacturing processes and equipment. We have developed and continue to develop and improve novel and sophisticated processes and equipment for the manufacture of our Triage Meter platform products. Significant additional resources, implementation of additional automated and semi-automated manufacturing equipment or changes to our manufacturing processes were, and may continue to be, required for the scaling-up of each new product prior to commercialization, or in order to adjust to changes in customer demand once commercialization begins, and this work may not be completed successfully or efficiently.
Our San Diego manufacturing facility is a registered medical device establishment with the FDA and a licensed medical device manufacturer with the California State Department of Health & Human Services. We have also been licensed and certified to manufacture products using controlled substances by the U.S. Drug Enforcement Agency. We received ISO 9001 re-certification in 2005.
Sales and Marketing As of December 31, 2006, we had 231 employees, worldwide, in various sales and marketing functions. In the United States, we employ a direct sales force and utilize Fisher, PSS and Henry Schein to distribute our products to our primary markets, hospitals and physician offices. We also employ a field-based network of clinically experienced individuals that support the sales force by providing pre- and post- sales education and training. In international markets, we have established direct selling efforts in several countries and we utilize a network of country-specific and regional distributors in other areas.
Strategic and Distribution Arrangements
Fisher HealthCare Division of Thermo Fisher Scientific Company
We have a distribution agreement under which Fisher distributes our products primarily to hospitals within the United States. The term of our current distribution agreement with Fisher expires on December 31, 2008. Under the agreement, Fisher’s distribution rights are semi-exclusive in the U.S. hospital market and non-exclusive in the U.S. physician office market. Either party has the right to terminate the agreement in the case of an uncured breach by the other party. In addition, under certain circumstances, the distribution relationship may become non-exclusive or terminate with prior notice. For instance, if during a six-month period our direct sales to customers in the U.S. hospital market exceed a specified percentage of the total sales of our products by both us and Fisher in that market segment, Fisher will have the option of converting the agreement to a mutually non-exclusive arrangement. The specified percentage of direct sales in the contract that would trigger this option far exceeds the current level of direct sales. If Fisher were to exercise the option, either party would have the ability to terminate the agreement upon prior notice to the other party. Similarly, if Fisher elects to promote and sell certain products that are competitive with our products, then we will have the option of converting the agreement to a mutually non-exclusive arrangement. If we were to exercise that option, either party would have the ability to terminate the agreement upon prior notice to the other party. Sales to Fisher represented 81%, 84% and 86% of our product sales in 2006, 2005, and 2004, respectively.
LRE Technology Partner GmbH
We have an agreement with LRE for the manufacturing and supply of the Triage Meter, which is used with our rapid Triage BNP Test, as well as with the Triage Cardiac Panel, Triage CardioProfiler Panel, Triage D-Dimer Test, Triage Profiler SOB Panel and the Triage TOX Drug Screen. All of our products in development are also intended to be used with the Triage Meter. Under the terms of the LRE agreement, LRE manufactures the Triage Meter according to specifications provided by us. LRE is our exclusive supplier of the Triage Meter during the term of the current LRE agreement, which expires in February 2008. We purchase the Triage Meter from LRE in Euros through firm purchase orders on a per meter price basis.
Beckman Coulter, Inc.
We have an agreement with Beckman Coulter under which it manufactures the Triage BNP Test for Beckman Coulter Immunoassay Systems for us, and we exclusively sell and market the product. Although this product runs on Beckman Coulter’s automated immunoassay analyzers, it is designed to provide results standardized to match our Triage BNP Test for the Triage Meter. We began selling the product in Europe in December 2003 and in the United States in January 2004.
Biosite Discovery
Biosite Discovery is a collaborative research and in-licensing program dedicated to the identification and evaluation of new protein targets for acute diseases. Through Biosite Discovery, we conduct analyses on both known proteins that may be markers of disease and proteins accessed from commercial and clinical collaborators in order to determine diagnostic utility. Since 1999, we have initiated over 50 license and collaboration agreements relating to our discovery program including arrangements with Amgen Inc., Amylin Pharmaceuticals, Inc., Cincinnati Children’s Research Foundation and Columbia University, The Cleveland Clinic Foundation and PrognostiX, Inc., Compugen, Ltd, Inc., Eli Lilly and Company, FivePrime Therapeutics, Inc., Incyte Corporation, Lexicon Genetics, Inc., Medarex, Inc., Novartis Pharma AG, Oxford Genome Sciences (UK) Ltd. and Power3 Medical Products, Inc. In parallel, we have initiated over 100 clinical collaboration agreements with leading universities, hospitals and health systems. Also under Biosite Discovery, we have executed several license or cross-license agreements with companies such as BioInvent International, MorphoSys AG and Dyax Corp.
Proprietary Technology and Patents
Our intellectual property portfolio includes patents, patent applications, trade secrets, know-how and trademarks. Our success will depend in part on our ability to obtain additional patents, maintain trade secrets and operate without infringing the proprietary rights of others, both in the United States and in other countries.
We periodically file patent applications to protect the technology, inventions and improvements that may be important to the development of our business. We rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position. We file patent applications on our own behalf as assignee and, when appropriate, have filed and expect to continue to file, applications jointly with our collaborators. These patent applications cover, among other things, devices, compositions of matter, methods of treatment, methods of discovery, use of novel compounds, and novel modes of action that are important in our research and development activities. As of February 10, 2007, we had been issued approximately 90 U.S. patents, and had been granted approximately 140 patents in other countries. These patents have expiration dates (not including any patent term extensions) ranging from 2009 to 2021. We have also licensed a significant number of other patents and patent applications from third parties. For example, we licensed technology and patents relating to our Triage BNP Tests from Scios, Inc., a division of Johnson & Johnson. We also continue actively to seek patent protection in the United States and in foreign countries, and we intend to file additional patent applications relating to our technology and to specific products, as we consider appropriate.
To protect our rights to know-how and technology, we also ask our employees, technical consultants and advisors, and collaborators to enter into confidentiality agreements prohibiting the unauthorized use of, and restricting the disclosure of, confidential information and requiring disclosure and assignment to us of their ideas, developments, discoveries and inventions. In connection with our research and development activities, we also sponsor research at various outside institutions. Generally, under these agreements, we fund the work of investigators in exchange for the results of the specified work and the right or option to a license to any patentable inventions that may result in certain designated areas. If the sponsored work produces patentable subject matter, we generally either own the rights, or have the first right to negotiate for license rights, related to that subject matter. Any resulting license would be expected to require us to pay royalties on net sales of licensed products.
Our ability to obtain and enforce patents is uncertain and involves complex legal and factual questions, and we cannot guarantee that any patents will issue from any pending or future patent applications owned by or licensed to us. In addition, because patent applications in the United States are maintained in secrecy for eighteen months after the filing of the applications, and publication of discoveries in the scientific or patent literature often lag behind actual discoveries, we cannot be sure that the inventors of subject matter covered by our patents and patent applications were the first to invent or the first to file patent applications for these inventions. In the event that a third party has also filed a patent on a similar invention, we may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office, and similar proceedings in foreign jurisdictions, to determine priority of invention, which could result in a loss of our patent position. Furthermore, we may not have identified all U.S. and foreign patents that pose a risk of infringement.
Government Regulation
The testing, manufacture and sale of our products are subject to regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies. Pursuant to the Federal Food, Drug and Cosmetic Act, the FDA regulates the pre-clinical and clinical testing, manufacture, labeling, distribution and promotion of medical devices. In the United States, we are not able to commence interstate
marketing or commercial sales of new products under development until we receive clearance or approval from the FDA, which can be a lengthy, expensive and uncertain process. Clearance or approval to commercially distribute new medical devices is generally received from the FDA through clearance of a Premarket Notification 510(k) or approval of a Premarket Approval Application.
The Premarket Notification 510(k), or 510(k), process requires us to demonstrate substantial equivalence to a medical device first marketed in interstate commerce prior to May 1976, the enactment date of the Medical Device Amendments. We must submit data that supports our claim of substantial equivalence. For any devices that are cleared through the 510(k) process, modifications or enhancements that could significantly affect safety or effectiveness, or constitute a major change in the intended use of the device, will require new 510(k) submissions. It generally takes from three to five months to obtain 510(k) clearance but can take longer or not at all.
A Premarket Approval Application, or PMA, must be filed if a new device is not substantially equivalent to a medical device first marketed in interstate commerce prior to May 1976. A PMA application must be supported by valid scientific evidence to demonstrate the safety and effectiveness of the device, typically including the results of human clinical investigations, bench tests and laboratory studies. The PMA approval process can be expensive, uncertain and lengthy, and many devices for which FDA approvals of PMA applications have been sought by other companies have never been approved for marketing.
Both before and after a product is commercialized, we have ongoing responsibilities under the regulations of the FDA and other regulatory agencies. Noncompliance with applicable laws and the requirements of the FDA and other agencies can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant pre-market clearance or pre-market approval for products, withdrawal of marketing clearances or approvals, and criminal prosecution. The FDA has the authority to request recall, repair, replacement or refund of the cost of any product manufactured or distributed by us if the product is found to be adulterated. The FDA also administers certain controls over the export of medical devices from the United States.
The use of our products is affected by the Clinical Laboratory Improvement Amendments of 1988, or CLIA, and related federal and state regulations, which provide for regulation of laboratory testing. The scope of these regulations includes quality control, proficiency testing, personnel standards and federal inspections. Under CLIA quality control rules in effect from 1992 through 2002, laboratories using “unitized” test systems were in compliance with CLIA if they followed the manufacturers’ instructions for daily quality control, or QC, by relying on the internal controls built into unitized test systems, including our Triage products.
We are also subject to the regulatory approval and compliance requirements for each foreign country to which we export our products. In the European Union, a single quality system and regulatory approval process has been created, and the quality system is represented as ISO certification and the regulatory registration process is represented by CE marking.
WHERE YOU CAN FIND MORE INFORMATION Our Internet address is www.biosite.com. We make available, free of charge, on our website at www.biosite.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, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or SEC. We also post copies on our website of our current charters for each committee of our board of directors, as well as our current Code of Business Conduct and Ethics, Corporate Governance Guidelines and Whistleblower Policy Statement. Currently, our board of directors maintains an Audit Committee, Compensation Committee, Nominating and Corporate Governance Committee and Stock Option Committee. The information found on our website shall not be deemed incorporated by reference by any general statement incorporating by reference this report into any filing under the Securities Act of 1933 or under the Securities Exchange Act of 1934, except to the extent we specifically incorporate the information found on our website by reference, and shall not otherwise be deemed filed under such Acts. All of the referenced documents are also available free of charge to any stockholder upon request. Requests should be submitted to Investor Relations, Biosite Incorporated, 9975 Summers Ridge Rd., San Diego, California 92121.
Item 1A.
Item 1A. Risk Factors This Annual Report on Form 10-K includes forward-looking statements about our business and results of operations that are subject to risks and uncertainties. See “Forward-Looking Statements” above. Factors that could cause or contribute to such differences include those discussed below. In addition to the risk factors discussed below, we are also subject to additional risks and uncertainties not presently known to us or that we currently deem immaterial. If any of these known or unknown risks or uncertainties actually occur, our business could be harmed substantially.
Our quarterly and annual revenues and operating results may fluctuate. We may not maintain profitability.
We have reported consecutive quarterly operating profits since the third quarter of 1999, after incurring quarterly operating losses during the prior seven quarters. In the future, our quarterly or annual operating results may fluctuate and we may not be able to maintain profitability. We believe that our future operating results may be subject to quarterly and annual fluctuations due to a variety of factors, including:
· our ability to promote and sell products in the markets in which we compete, including the hospital market, the physician office market and international markets;
· competition, including from products competitive with our Triage BNP Tests and from companies with greater financial capital and resources;
· competitive pressures on average selling prices of our products;
· research and development efforts, including clinical studies and new product scale-up activities;
· market acceptance of our existing products and products under development;
· whether and when we successfully develop, attain regulatory approvals and introduce new products;
· changes in the mix of products sold;
· seasonal or unanticipated changes in customer demand or the timing of significant orders;
· manufacturing problems, inefficiencies, capacity constraints, backlog or delays;
· regulatory changes, uncertainties or delays;
· effectiveness in transitioning and operating a direct sales distribution model in certain international countries and expenses associated with these activities;
· changes in reimbursement policies;
· the impact of non-cash expenses attributable to stock-based payments;
· costs, timing and effectiveness of further expansion of our sales force and field support resources;
· our ability to execute, maintain and achieve performance milestones under licenses and collaborative agreements;
· product recalls;
· prosecution, defense and resolution of license, patent or other contract disputes;
· costs and timing associated with business development activities, including potential licensing of technologies or intellectual property rights; and
· changes in accounting or tax standards or practice.
Our operating results would also be adversely affected by a downturn in the market for our products or slower than anticipated product sales growth, including as a result of market saturation of our products. We continue to increase our operating expenses to support our expanded sales and marketing activities, manufacturing operations and new product development. Therefore, our operating results would be adversely affected if our sales and gross profits did not correspondingly increase at the same or higher rate or if our product development efforts are unsuccessful or subject to delays. Accurate prediction of future operating results is difficult or impossible. We may not achieve revenue growth or sustain profitability on a quarterly or annual basis, and our growth or operating results may not be consistent with predictions made by us or by securities analysts.
Valuation of stock-based payments, which we are required to perform for purposes of recording compensation expense under FAS 123(R), involves significant assumptions that are subject to change and difficult to predict.
On January 1, 2006, we adopted FAS 123(R), Share-Based Payment, which requires that we record compensation expense in the statement of income for stock-based payments, such as employee stock options and our employee stock purchase plan, using the fair value method. As long as stock-based awards are utilized as part of our compensation strategy, the requirements of FAS 123(R) have had, and will continue to have, a material effect on our future financial results reported under United States Generally Accepted Accounting Principles, or U.S. GAAP, and make it difficult for us to accurately predict our future financial results.
For instance, estimating the fair value of stock-based payments is highly dependent on assumptions regarding the future exercise behavior of our employees and changes in our stock price. Our stock-based payments have characteristics significantly different from those of freely traded options, and changes to the subjective input assumptions of our stock-based payment valuation models can materially change our estimates of the fair values of our stock-based payments. In addition, the actual values realized upon the exercise, expiration, early termination or forfeiture of stock-based payments might be significantly different than our estimates of the fair values of those awards as determined at the date of grant. Moreover, we rely on various third parties, such as E*Trade Financial Corporate Services and Aon Consulting, that either supply us with information or help us perform certain calculations that we employ to estimate the fair value of stock-based payments. If any of those parties do not perform as expected or make errors, we may inaccurately calculate actual or estimated compensation expense for stock-based payments.
FAS 123(R) could also adversely impact our ability to provide accurate guidance on our future financial results as assumptions that are used to estimate the fair value of stock-based payments are based on estimates and judgments that may differ from period to period. For instance, we may be unable to accurately predict the timing, amount and form of future stock-based payments to employees. We may also be unable to accurately predict the amount and timing of the recognition of tax benefits associated with stock-based payments as they are highly dependent on the exercise behavior of our employees and the price of our stock relative to the exercise and price fair value of each outstanding stock option.
For those reasons, among others, FAS 123(R) may create variability and uncertainty in the compensation expense we will record in future periods, potentially negatively impacting our ability to provide accurate financial guidance. This variability and uncertainty could further adversely impact our stock price and increase our expected stock price volatility as compared to prior periods.
We are dependent on the market acceptance of our existing products and products under development for revenue growth and profitability.
We believe that our revenue growth and profitability will substantially depend upon our ability to expand market acceptance and sales of our existing products, such as the Triage BNP Tests, Triage Cardiac Panel, Triage CardioProfiler Panel, Triage Profiler Shortness of Breath Panel, Triage D-Dimer Test and, subject to obtaining appropriate regulatory approvals, our products currently under development, such as the Triage MPO tests and other tests for ACS, sepsis, acute kidney injury and stroke. Our revenue growth will also depend on our effectiveness in transitioning to and operating a direct sales and distribution model in certain international countries, and on our ability to appropriately manage our operating expenses and our capital expenditures to optimize our profitability. We have made and continue to make significant investments in headcount, manufacturing equipment, facilities and infrastructure to address our current and planned future revenue growth. We are also making significant investments in new market segments in the United States, such as physician office testing and expanding our sales force and commercial infrastructure in Europe. These investments and commitments are predicated on assumptions of market acceptance of our products, sales force effectiveness and revenue growth.
If we fail to plan, establish and maintain:
· a cost-effective sales force, customer education and product support resource base, and administrative infrastructure;
· effective marketing to customers, especially in markets where we have limited experience or significant competition;
· appropriate strategies or tactics to address our competitors;
· reliable, cost-efficient, high-volume manufacturing capacity; or
· an effective distribution system for our products,
sales of our products may not meet expectations and our profitability may suffer.
If we do not successfully develop new products and new manufacturing processes as currently planned, we may not recover our significant investments in those projects.
We are investing in the research and development of potential new products, including products for ACS, sepsis, acute kidney injury and stroke and of expanded uses of our existing products. In certain cases, the successful development of our new products will depend on the development of new technologies. We are also making significant investments in processes and equipment to improve our manufacturing efficiency and capacity, in anticipation of new products and revenue growth, as well as in the construction and purchase of new facilities. Our
revenue growth and profitability are impacted by these investments. We are required to undertake time consuming and costly development and clinical trial activities and seek regulatory approval for potential new products and for potential new uses of existing products. Products that appear promising during product development and preclinical studies, including our Triage MPO Test and other tests for sepsis, acute kidney injury and stroke, may not demonstrate clinical study results needed to support regulatory approval, or other parties have or may have patent or other proprietary rights to our potential new products, and may not allow us to sell them on reasonable terms, or at all. We may experience difficulties that could delay or prevent the successful development, introduction or market acceptance of any such new products.
Our operating results will be adversely affected if we are unable, for technological or other reasons, to:
· complete new product development in a timely manner;
· properly design, initiate and complete appropriate clinical studies when expected in order to validate the use of potential new products or expanded use of existing products;
· implement or effectively or efficiently scale-up manufacturing for new products that meet required quality standards;
· on a timely basis, obtain regulatory approval or clearance to market a new product for an intended use or an existing product for an alternative use; or
· complete capital projects, including projects intended to automate portions of our manufacturing processes, in a timely manner or at all.
Our Triage BNP Tests have encountered, and may continue to encounter, significant competition from products developed and commercialized by companies with greater financial capital and resources.
Product sales of our Triage BNP Tests represented 65% and 67% of our product sales in 2006 and 2005, respectively. Our Triage BNP Tests are currently two of several FDA-cleared tests used to aid in the diagnosis of heart failure. Siemens, Dade Behring, Roche Diagnostics, Abbott Laboratories and Ortho Clinical Diagnostics, a subsidiary of Johnson & Johnson, have launched competitive tests at various times since November 2002. Shionogi & Co., Ltd. sells a BNP radioimmunoassay product for research purposes only in the United States. The risk of competition may continue to grow as other potential competitors gain access to competing technologies, such as NT-pro BNP, which Roche Diagnostics is offering for license.
We have experienced, and continue to experience, competition from these companies and anticipate competition from others in the future. It is also possible that other new competitors will enter the market. In the market for BNP testing specifically, Abbott Laboratories now offers a BNP test on its i-STAT meter product, which is designed for use at the point-of-care. These and other competitors may succeed in developing or marketing products that are more effective or commercially attractive than the Triage BNP Tests. Moreover, we may not have the financial resources, technical expertise or marketing, distribution or support capabilities to successfully compete with these and other competitors in the future.
Competition and technological change in the diagnostic testing market may make our products less attractive or obsolete.
In addition to the specific competitive risks that we face in the market for our Triage BNP Tests, we face intense competition for our other products and in the general market for diagnostic testing. Our competitors include:
· companies making laboratory-based tests and analyzers;
· clinical reference laboratories; and
· other rapid diagnostic product manufacturers.
Currently, the majority of diagnostic products used by physicians and other healthcare providers are performed by independent clinical reference laboratories and hospital-based laboratories using automated testing systems. Therefore, with the exception of our Triage BNP Test for Beckman Coulter Immunoassay Systems, in order to achieve market acceptance for our products we will be required to demonstrate that our products provide clinical, cost-effective and time saving alternatives to automated tests traditionally used by clinical reference laboratories or hospital-based laboratories. Over time, this has become progressively more difficult as heart failure testing is now more widely available on automated testing systems.
Our competitors have developed or are developing diagnostic products and/or testing systems that do or will compete with our products. Many of our competitors have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than we do.
Moreover, these competitors offer broader product lines and have greater name recognition than we do, and offer discounts as a competitive tactic. In addition, several smaller companies are currently making or developing products that compete with or will compete with our products. We utilize semi-exclusive arrangements with selected healthcare group purchasing organizations, or GPOs, and long-term contracts with some of our customers as a method of defending against competition. Such contracts are of varying terms and expiration dates. Expiring contracts with GPOs and customers may not be renewed and long-term contracts may not be acceptable to new customers, which could harm our competitive strategy.
Our competitors may succeed in developing or marketing technologies or products that are more effective or commercially attractive than our products, or that would render our technologies and products obsolete. The success of our competitors, many of whom have made substantial investments in competing technologies, or our failure to compete successfully, may prevent, limit or interfere with our ability to make, use or sell our products in either the United States or in international markets.
The impact of consolidation of several major competitors in the market for immunoassay testing is difficult to predict and may harm our business.
The market for immunoassay-based diagnostic testing is rapidly changing as a result of recent consolidation in the industry. Within the past 12 months, Bayer Diagnostics and Diagnostic Products Corp were both acquired by Siemens AG. In addition, in January 2007 GE announced that it entered into a definitive agreement to purchase the laboratory diagnostics business of Abbott Laboratories, including Abbott’s i-STAT product line. Both Siemens and GE have significant existing businesses in related markets for healthcare equipment and services, such as diagnostic imaging. Given the short period of time since the announcement of these transactions, it is unclear how these completed and proposed acquisitions will impact the competitive landscape for our products or for hospital-based diagnostic testing more generally. However, because these competitors sell a broad range of product offerings to our hospital customers and because of the substantially greater financial resources and more established marketing, sales and service organizations that they each have, we believe there is greater risk that these new consolidated competitors may offer discounts as a competitive tactic or may hold other competitive advantages as a result of their ability to sell a broader menu of important hospital infrastructure equipment and information systems on a combined or bundled basis.
The effect of market saturation may negatively affect the sales of our products, including our Triage BNP Tests.
The growth in our product sales in recent periods has been driven primarily by growth in the sales volumes of our Triage BNP Tests. For example, growth in the sales unit volume of our Triage BNP Tests represented 41% and 69% of our total product sales volume growth for 2006 and 2005, respectively. Our meter-based Triage BNP Test, launched domestically in January 2001, was the first blood test available to aid in the detection of heart failure and benefited from a first to market position until the entry of direct competition in June 2003. Today, our Triage BNP Test products are among several FDA-cleared products for the use as an aid in the diagnosis of heart failure.
As the acute care and initial diagnosis market segment for natriuretic testing in the U.S. hospital setting becomes saturated, we expect the growth rates of sales unit volume for our Triage BNP Tests in 2007 and future periods to be lower than the growth rates we experienced over the past several years. We have historically experienced decreases in sales growth rates related to market saturation for our other products, such as our Triage Drugs of Abuse Panel products. Unless we are able to successfully introduce new products into the market and achieve market acceptance of those products in a timely manner, the effect of market saturation on our existing products may negatively impact our product sales, gross margins and financial results. Even if we are able to successfully commercialize any new products, we may not experience sales growth rates for those products that are similar to the sales growth rates we achieved with our Triage BNP Tests. In addition, as the market for BNP testing matures and more competitive products become available, the average sales price for our Triage BNP Tests is likely to decline, which will adversely impact our product sales, gross margins and our overall financial results.
Concentration of sales under arrangements with group purchasing organizations may negatively impact our bargaining power and profit margins.
During 2006, approximately 20% of our total worldwide product sales, and 23% of our domestic product sales, were made to healthcare provider institutions that are members of three GPO’s, HealthTrust Purchasing Group, Broadlane, Inc. and Consorta, Inc. GPOs represent the interests of their members and negotiate pricing, exclusivity and other terms and conditions for the purchase of our products on behalf of their member institutions. We have entered into agreements with these GPOs that are of varying lengths and carry varying levels of product exclusivity and product pricing. During the effective period of an agreement, the member institutions of a GPO can elect
whether to purchase products from us based on those pre-negotiated terms. Because of the significant concentration of product sales to these GPO members today and the growing membership of the GPOs themselves due to organic growth and consolidation in the GPO industry, there is significant competition to gain or maintain access to the member institutions of certain GPOs. As a result, these GPOs have more negotiating leverage against us today compared to when we originally started doing business with them. In particular, because of this purchasing leverage, the GPOs may put pressure on our pricing and extract other terms and conditions that could adversely affect our operating results and profit margins, including seeking price adjustments to match pricing we offer to other GPOs or healthcare institutions. Any pricing change under a GPO contract may result in a pricing change for a significant number of our customers at a single point or over a very short period of time, negatively impacting our product sales and gross margins both in the near term and in the long term. The results of these developments may have a material adverse effect on our product sales and results of operations.
We are dependent on key distributors and have limited direct distribution experience. If any of our distribution relationships are terminated, or our distributors fail to adequately perform, our operating expenses will increase and our product sales may decrease.
We primarily rely upon Fisher for distribution of our products in the U.S. hospital market and may rely upon Fisher or other distributors to distribute new products or our existing products in other markets. Fisher accounted for 81% and 84% of our product sales in 2006 and 2005, respectively. We have a distribution agreement with Fisher that expires on December 31, 2008. In November 2006, Fisher Scientific Company completed a merger with Thermo Electron Corporation. At this time, we are unable to predict the effect, if any, the merger will have on our distribution relationship with Fisher.
We distribute products in the United States physician office market primarily through PSS and Henry Schein. Internationally, we distribute products through country-specific and regional distributors, as well as through our direct sales force in selected countries. The loss or termination of one or more of our distributors could have a material adverse effect on our sales in the market served by that distributor.
Furthermore, if any of our distribution or marketing agreements are terminated or expire, and we are unable to enter into alternative agreements or if we elect to distribute our products directly, we will have to invest in additional sales, marketing and administrative resources, including additional field account executives and customer support resources, which would significantly increase our expenses. For instance, if we distribute our products directly to customers, we would need to hire additional personnel and would incur additional expenses relating to customer order processing and servicing, warehousing, shipping, billing and collections, which are costs that our distributors currently bear. We may also need to invest in additional capital equipment, third-party services and facilities in order to administer the logistics of direct distribution. Changes in the distribution of our products may also result in contract termination fees, transition-related expenses, disruption of our business, increased competition and lower product sales and operating profits. In addition, following the expiration or termination of any distribution agreement, a former distributor may attempt to compete directly with us by offering competitive products to our current customers.
We have limited experience in direct sales, marketing and distribution of our products, both domestically and internationally. In the event of a termination of any of our distribution arrangements, our direct sales, marketing and distribution efforts may not be successful and we may not be able to successfully transition from a distributor model to a direct sales model. Further, we may not be able to enter into new distribution or marketing agreements on satisfactory terms, or at all. A failure to enter into acceptable distribution agreements, to successfully market our products or to implement the logistics associated with direct product distribution to our customers, would have a material adverse effect on us.
We may be unable to accurately predict future sales through our distributors, which could harm our ability to efficiently manage our internal resources to match market demand.
A significant portion of our product sales is made to Fisher and other distributors both domestically and internationally. As a result, our financial results, quarterly product sales, trends and comparisons are affected by seasonal factors and fluctuations in the buying patterns of end-user customers, Fisher and our other distributors, and by the changes in inventory levels of our products held by these distributors. For example, higher utilization rates of our Triage BNP Tests may be due to a higher number of ED visits by patients exhibiting shortness of breath, a symptom of heart failure and of influenza. However, higher utilization may also result from greater awareness, education and acceptance of the uses of our Triage BNP Tests, as well as from additional users within the hospitals.
We are not always able to verify the inventory levels of our international distributors and only have limited visibility over the inventory levels of our products at Fisher or our other domestic distributors. While we attempt to assist Fisher in maintaining targeted stocking levels of our products, we may not be successful. Attempting to assist Fisher in maintaining targeted stocking levels of our products involves the exercise of judgment and use of assumptions about future uncertainties including end-user customer demand and, as a result, actual results could differ from our estimates. Inventory levels of our products held by distributors may exceed or fall below the levels we consider desirable on a going-forward basis, which may harm our future financial results. This may result from unexpected buying patterns of our distributors or from our inability to efficiently manage or invest in internal resources, such as manufacturing capacity, to meet the actual demand for our products. In addition, if we begin direct distribution in any territory following the expiration or termination of a distribution agreement for that territory, it is likely that our product sales in that territory will decrease as our prior distributor sells its remaining inventory of our products.
Before we commercialize and sell any of our potential products, we must conduct clinical studies. If the results of these clinical studies are not available when expected or do not demonstrate the anticipated utility of those potential products, we may not be able to sell future products and our sales could be adversely affected.
Before we can sell any products, we must conduct clinical studies intended to demonstrate that our potential products perform as expected. The results of these clinical studies are used as the basis to obtain regulatory approval from government authorities such as the FDA. Clinical studies are experiments conducted using our potential product candidates involving human patients having the diseases or medical conditions we are trying to evaluate or diagnose. Conducting clinical studies is a complex, time-consuming and expensive process. We are required to conduct clinical studies using an appropriate number of study sites and patients to support the product label claims we are seeking. The length of time, number of study sites and patients required for clinical studies vary substantially according to the type, complexity, novelty and intended use of the potential product, and therefore, we may spend as much as several years completing certain studies.
In addition, we face additional risks relating to the design of our clinical studies because of the rapidly evolving standard of care and diagnosis for certain diseases and conditions that we are working on, such as sepsis, kidney injury and stroke. For these diseases and conditions, the duration of time needed to complete certain clinical studies may result in the design of such clinical studies being based on an out-of-date standard of medical care, limiting the utility and application of such studies. In addition, varying standards of care among study sites may result in a determination by regulatory authorities that the data collected from those varying sites may not be aggregated when performing any statistical analyses from the studies.
Our ability to timely complete our clinical studies depends in large part on a number of key factors including protocol design, regulatory and institutional review board input and approval and the rate of patient enrollment and retention in clinical studies. Patient enrollment is a function of several factors, including the size and location of the patient population, enrollment criteria and competition with other clinical studies for eligible patients. As such, there may be limited availability of patients who meet the criteria for certain clinical studies. Clinical studies may also be delayed as a result of insufficient supply or deficient quality of materials necessary for the performance of clinical studies or as a result of difficulties in coordinating clinical study activities with third-party clinical study sites and other service providers, such as external auditors. Delays in planned clinical studies can result in increased development costs, delays in regulatory approvals and associated delays in potential products reaching the market.
The number, size, duration and complexity of our clinical studies has increased and we expect will continue to increase significantly in 2007. Due to the number of large-scale clinical studies recently initiated and planned this year, we expect to see further accelerated growth in research and development expense in 2007 as compared to 2006. To execute our clinical study programs, we need to accelerate the growth of our development organization, implement new management structures and approaches and increase dependence on third-party contract clinical study providers.
If we fail to adequately manage the increasing number, size and complexity of our clinical studies, our clinical studies and corresponding regulatory approvals may be delayed or we may fail to gain approval for our potential product candidates altogether. Even if we successfully manage our clinical studies, we may not obtain favorable results and may not be able to obtain regulatory approval on the basis of our current and planned studies. If we are unable to market and sell our new products or are unable to obtain approvals in the timeframe needed to execute our product strategies, our business and results of operations would be materially and adversely affected.
The process of obtaining clearance or approval to market new medical devices in the United States is expensive, time consuming and uncertain. We may not obtain required approvals for the commercialization of our products in the United States in a timely manner, if at all.
Our future performance depends on, among other matters, our estimates as to when and at what cost we will receive regulatory approval for new products. Regulatory approval can be a lengthy, expensive and uncertain process, making the timing, cost and ability to obtain approvals difficult to predict.
In the United States, clearance or approval to commercially distribute new medical devices is received from the FDA through clearance of a Premarket Notification, or 510(k), or through approval of a PMA. To receive 510(k) clearance, a new product must be substantially equivalent to a medical device first marketed in interstate commerce prior to May 1976. The FDA may determine that a new product is not substantially equivalent to a device first marketed in interstate commerce prior to May 1976 or that additional information is needed before a substantial equivalence determination can be made. A “not substantially equivalent” determination, or a request for additional information, could prevent or delay the market introduction of new products that fall into this category. The 510(k) clearance and PMA approval processes can be expensive, uncertain and lengthy. It generally takes from three to five months from submission to obtain 510(k) clearance, and from six to eighteen months from submission to obtain PMA approval; however, it may take longer, and 510(k) clearance or PMA approval may never be obtained.
For devices that are cleared through the 510(k) process, modifications or enhancements that could significantly affect safety or effectiveness, or constitute a major change in the intended use of the device, require new 510(k) submissions. We have made modifications to some of our products since receipt of initial 510(k) clearance. With respect to several of these modifications, we filed new 510(k)s describing the modifications and received FDA 510(k) clearance. We made other modifications to some of our products that we believe do not require the submission of new 510(k)s. The FDA may not agree with any of our determinations not to submit a new 510(k) or PMA for any of these modifications made to our products. If the FDA requires us to submit a new 510(k) or PMA for any device modification, we may be prohibited from marketing the modified products until the new submission is cleared by the FDA.
The FDA has made, and may continue to make, changes in its approval requirements and processes. We cannot predict what these changes will be, how or when they will occur or what effect they will have on the regulation of our products. Any new regulations may impose additional costs or lengthen review times of our products. Delays in receipt of or failure to receive United States regulatory approvals or clearances for our new products would have a material adverse effect on our business, financial condition and results of operations.
Because we export our products to foreign countries, we are also subject to applicable regulatory approval requirements in those countries, which may impose additional costs upon us or prevent or delay us from marketing our products in those countries.
In addition to regulatory requirements in the United States, we are also subject to the regulatory approval requirements for each foreign country to which we export our products. In the European Union, for example, the In Vitro Diagnostic Directive Medical Device Directive, or IVDD, mandates requirements for a quality management system and technical product information. Regulatory compliance with the IVDD is represented by affixing the “CE” mark to product labeling. Depending on product classification, the IVDD requirements may entail review by an European Union Member State Notified Body or self-certification by the manufacturer. Although all of our products are currently eligible for CE marking through self-certification, this process can be lengthy and expensive. As another example, in Canada, our products require approval by Health Canada prior to commercialization along with International Standards Organization, or ISO, 13485/CMDCAS certification. It generally takes three to six months from submission to obtain a Canadian Device License. In some cases, device license approval may take longer or may not be obtained at all. Any changes in foreign approval requirements and processes may cause us to incur additional costs or lengthen review times of our products. We may not be able to obtain foreign regulatory approvals on a timely basis, if at all, and any failure to do so may cause us to incur additional costs or prevent us from marketing our products in foreign countries, which may have a material adverse effect on our business, financial condition and results of operations.
We are subject to ongoing regulation of the products for which we have obtained regulatory clearance or approval, among other things, which may result in significant costs or in certain circumstances, the suspension or withdrawal of previously obtained clearances or approvals.
Any products for which we obtain regulatory approval or clearance continue to be extensively regulated by the FDA and other federal, state and foreign regulatory agencies. These regulations impact many aspects of our
operations, including manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping. For example, our manufacturing facilities and those of our suppliers and distributors are, or can be, subject to periodic regulatory inspections. The FDA and foreign regulatory agencies may require post-marketing testing and surveillance to monitor the effects of approved products or place conditions on any product approvals that could restrict the commercial applications of those products. In addition, the subsequent discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. We are also subject to routine inspection by the FDA and certain state agencies for compliance with Quality System Requirement and Medical Device Reporting requirements in the United States and other applicable regulations worldwide, including but not limited to ISO regulations. In addition to product-specific regulations, we are subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. We may incur significant costs to comply with these laws and regulations. If we fail to comply with applicable regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products or injunctions against their distribution, disgorgement of money, operating restrictions and criminal prosecution.
Changes in U.S. laboratory regulations for our customers may adversely affect us.
The use of our products is affected by CLIA and related federal and state regulations, which provide for regulation of laboratory testing. The scope of these regulations includes quality control, proficiency testing, personnel standards and federal inspections.
Under CLIA quality control rules in effect from 1992 through 2002, laboratories using “unitized” test systems, including our Triage products, were in compliance with CLIA if they followed the manufacturers’ instructions for daily quality control, or QC, by relying on the internal controls built into unitized test systems. On January 24, 2003, the Centers for Medicare and Medicaid Services, or CMS, publicly issued a final QC rule under CLIA, which went into effect on April 24, 2003. So long as laboratory directors, at a minimum, review manufacturers’ QC instructions, find those instructions to reasonably monitor the accuracy of the analytic process and the laboratory then follows those manufacturers’ instructions, the QC requirements contained in the 2003 modifications of the CLIA regulations will be satisfied. Future amendments of CLIA, the promulgation of additional regulations or guidelines impacting laboratory testing, and uncertainties relating to the enforcement of CLIA may have a material adverse effect on our ability to market our products, our business and financial condition, our results of operations and our customers’ access to our products.
Diagnostic test systems are classified into one of three CLIA regulatory categories based on their potential risk to public health. Waived tests are the lowest regulated category and those most used in physician offices. In August 2005, we announced that the FDA granted a CLIA waiver to reclassify the Triage BNP Test used on our Triage Meter from CLIA moderately complex to waived.
Manufacturing risks and inefficiencies may adversely affect our ability to produce products and could reduce our gross margins and increase our research and development expenses.
We are subject to manufacturing risks, including our limited manufacturing experience with newer products and processes, which may hinder our ability to scale-up manufacturing. Additionally, unanticipated acceleration or deceleration of customer demand may lead to manufacturing inefficiencies. We must manufacture our products in compliance with regulatory requirements, in sufficient quantities and on a timely basis, while maintaining acceptable product quality and manufacturing costs. Significant additional resources, implementation of additional automated and semi-automated manufacturing equipment and changes in our manufacturing processes and organization have been, and may continue to be, required for the scale-up of each new product prior to commercialization or to meet increasing customer demand once commercialization begins, and this work may not be successfully or efficiently completed.
In addition, although we expect some of our newer products and products under development to share production attributes with our existing products, production of these products may require the development of new manufacturing technologies and expertise. It may not be possible for us, or any other party, to manufacture these products at a cost or in quantities to make these products commercially viable. If we are unable to develop or contract for manufacturing capabilities as needed, on acceptable terms, our ability to conduct pre-clinical and clinical testing will be adversely affected, resulting in delayed submissions for regulatory clearance or approval of products and initiation of other development programs, both of which would have a material adverse effect on us.
Manufacturing and quality problems have arisen and may arise in the future as we attempt to scale-up our manufacturing capacity and implement automated and semi-automated manufacturing methods. For instance, we have experienced problems with third-party contractors that work with us in connection with our development of automated and semi-automated manufacturing equipment and we continue to rely on third parties for the manufacture of much of our automated and semi-automated manufacturing equipment. Consequently, scale-up and implementation of automated and semi-automated manufacturing methods may not be achieved in a timely manner or at a commercially reasonable cost, or at all. In addition, we continue to make significant investments to improve our manufacturing processes and to design, develop and purchase manufacturing equipment that may not yield the improvements that we expect. Unanticipated acceleration and deceleration of customer demand for our products has resulted, and may continue to result, in inefficiencies or constraints related to our manufacturing, which has harmed and may in the future harm our gross margins and overall financial results. Such inefficiencies or constraints may also result in delays, lost potential product sales or loss of current or potential customers due to their dissatisfaction.
We are dependent on sole-source suppliers for our products. A supply interruption would harm us and investments intended to reduce future risks may not be successful.
Sole-source vendors provide some key components and raw materials used in the manufacture of our products. Any interruption in supply of a sole-sourced component or raw material would have a material adverse effect on our ability to manufacture these products until a new source of supply is qualified or alternative manufacturing processes are implemented and, as a result, would have a material adverse effect on us. In addition, an uncorrected impurity or supplier’s variation in a raw material, either unknown to us or incompatible with the manufacturing processes of our products, could have a material adverse effect on our ability to manufacture products. We have products under development that, if developed and subject to obtaining appropriate regulatory approvals, may require us to enter into additional supplier arrangements or implement alternative manufacturing processes. We may not be able to enter into additional supplier arrangements on commercially reasonable terms, or at all. We also may not be able to implement alternative manufacturing processes that are effective and cost efficient, or at all. Failure to obtain and maintain a supplier on acceptable terms, or at all, or the implementation of alternative processes for the manufacture of our future products, if any, could increase our manufacturing costs or limit our production capacity for one or more of our products, which would have a material adverse effect on us.
For example, we rely upon LRE for production of the fluorometer that is used with our Triage Meter platform products, which include the rapid Triage BNP Test, Triage Cardiac Panel, Triage CardioProfiler Panel, Triage Profiler Shortness of Breath Panel, Triage TOX Drug Screen and other products currently under development. In addition, we rely on Beckman Coulter to manufacture the Triage BNP Test for Beckman Coulter Immunoassay Systems and related calibrations and controls for us. If these or any other sole-source suppliers are unable or unwilling to manufacture sufficient quantities of the relevant items that meet our quality standards, we would be required to identify and qualify alternative suppliers. Although we generally maintain safety stock inventory levels of these items, which would allow us some time to identify and qualify alternative suppliers, a delay or inability to identify and qualify alternative suppliers may materially and adversely affect:
· our sales and profit margins;
· our ability to adequately service our existing customers and market our products to potential new customers;
· our ability to develop and manufacture products on a timely and competitive basis; or
· the timing of market introductions and subsequent sales of products.
From time to time we initiate internal projects to develop our own ability to manufacture components or materials that are currently sole-sourced from a third party. For instance, in September 2006, we completed the purchase of a facility in San Clemente, California which we intend to use to manufacture plastic parts that are currently purchased from a third party. This and other projects may require significant additional investments of capital, both up-front and on an ongoing basis, including dedicated headcount, facilities and equipment needs. If we are not able to successfully initiate and complete these projects, we may never recover our investments and our financial results could be harmed.
We have made significant investments for the purchase and construction of a plastics molding facility. If we are unable to commence production with anticipated efficiencies and product quality when expected, our manufacturing costs may increase and our financial results may be harmed.
In an effort to improve the quality of plastic parts that we use in our products, and to reduce the risk associated with purchasing those parts from a sole-sourced supplier, during 2006 we made significant investments for the purchase and start-up of a facility to manufacture plastic parts. These investments included the purchase of a new
facility, capital equipment and other improvements totaling over $8.0 million. To date we have hired nine employees to staff the new facility and expect to hire additional personnel upon commencement of manufacturing operations. If we are unable to commence the manufacture of plastic parts when expected, we will be required to continue to purchase plastic parts from our existing suppliers and we will concurrently incur the additional expense associated with the operation of our molding facility, which will harm our financial results. In addition, in the course of commencing operations of our molding facility, or if in the future we are unable to manufacture parts that meet our quality standards, we may incur significant expense relating to scrap. Further, because of the variability in raw material costs and other operating expenses, we are not certain that our manufacturing costs for plastic parts from our own facility will be lower than the prices we currently pay to purchase those products from third parties. If we are not able to commence the manufacture of plastic parts when expected and that meet our quality requirements, or if we are unable to manufacture these parts at a cost savings, we may never recover our investments and our financial results could be harmed.
Our patents and proprietary technology may not provide us with any benefit and the patents of others may prevent us from commercializing our products.
Our ability to compete effectively will depend in part on our ability to develop and maintain proprietary aspects of our technology, and to operate without infringing the proprietary rights of others or to obtain licenses to such proprietary rights. Our patent applications may not result in the issuance of any patents. Additionally, our patent applications may not have priority over others’ applications, or, if issued, our patents may not offer protection against competitors with similar technology. Any patents issued to us may be challenged, invalidated or circumvented in the future and the rights created thereunder may not provide a competitive advantage. Any of these circumstances could prevent us from selling any or all of our products. Others may have filed and in the future are likely to file patent applications that are similar or identical to ours. To determine the priority of inventions, from time to time, we participate in interference proceedings declared by the United States Patent and Trademark Office, or USPTO, and similar proceedings in foreign jurisdictions. These proceedings could result in a substantial cost to us.
Our products and activities may be covered by technologies that are the subject of patents issued to, and patent applications filed by, others. We have obtained licenses, and we may negotiate to obtain other licenses, for technologies patented by others. Some of our current licenses are subject to rights of termination and may be terminated. Our licensors may not abide by their contractual obligations and, as a result, may limit the benefits we currently derive from their licenses. We may not be able to renegotiate or obtain licenses for technology patented by others on commercially reasonable terms, or at all. We may not be able to develop alternative approaches if we are unable to obtain licenses and our current and future licenses may not be adequate for the operation of our business. The failure to obtain, maintain or enforce necessary licenses or to identify and implement alternative approaches would prevent us from operating some or all of our business and would have a material adverse effect on us.
We rely upon trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology. We may not be able to meaningfully protect our trade secrets, or be capable of protecting our rights to our trade secrets.
Legal proceedings to obtain patents and litigation of third-party claims of intellectual property infringement or relating to existing licenses could require us to spend substantial amounts of money and could impair our operations.
Litigation may be necessary to enforce any patents issued to us, to protect trade secrets or know-how owned by us, to determine the enforceability, scope and validity of the proprietary rights of others, or to enforce our rights under license and other intellectual property-related agreements. Litigation related to intellectual property matters has in the past, and may in the future, result in material expenses to us and be a significant diversion of effort by our technical and management personnel, regardless of the outcome. Litigation, if initiated, could seek to recover damages as a result of any sales of the products subject to the litigation and to enjoin further sales of such products. The outcome of litigation, both pending and potentially in the future, is inherently uncertain. An adverse outcome in any litigation or the failure to obtain a necessary license could subject us to significant liability and could prevent us from selling any or all of our products, which could have a material adverse effect on our business, financial condition and results of operations.
Our commercial success also depends in part on us neither infringing patents or proprietary rights of third parties nor breaching any licenses that may relate to our technologies and products. We are aware of several third-party patents that may relate to our technology. In addition, we have received and may in the future receive notices
claiming infringement from third parties as well as invitations to take licenses under third-party patents. We cannot be certain that we do not or will not infringe these patents, or other patents or proprietary rights of third parties. Any legal action against us or our collaborators, such as our recently settled litigation with Roche Diagnostics and certain of its affiliates, claiming damages and seeking to enjoin commercial activities relating to our products and processes affected by third-party rights, in addition to subjecting us to potential liability for damages, may require us or our collaborators to obtain a license in order to continue to manufacture or market the affected products and processes. We cannot be certain that our collaborators or we would prevail in any such action or that any license (including licenses proposed by third parties) required under any such patent would be made available on commercially acceptable terms, if at all. There are a significant number of U.S. and foreign patents and patent applications in our areas of interest, and we believe that there may be significant litigation in the industry regarding patent and other intellectual property rights.
We may not be successful in transitioning from the use of distributors in international markets to directly selling our products in those markets, which may result in lower product sales and higher expenses.
Until recently, we sold all of our products internationally through independent distributors. We transitioned to a direct sales and distribution model in France and Germany in 2003, in Belgium, Luxembourg, the United Kingdom and Italy in 2004, and in the Netherlands and Switzerland in 2006. Over the next few years, we may transition the distribution of our products in some additional international countries to a direct sales and distribution model. In any country in which we transition to a direct sales and distribution model, we will need to make significant investments in facilities, resources and personnel. In some instances, we may need to incur many of those expenses even before we complete the transition to a direct sales model. In addition, once we commence active sales and marketing activities we will assume additional administrative expenses to manage our operations in those countries. We may also incur expenses associated with the termination of our existing distribution arrangements in those countries. We possess limited experience in managing operations outside of the United States and in direct sales, marketing and distribution of our products in international markets. If our efforts to implement direct sales and distribution in countries where we elect to do so are unsuccessful, we may not achieve our projected sales objectives, and we may also incur additional expenses, or our operating profits may be lower than anticipated.
Our international sales and operations may be harmed by political, social or economic changes, or by other factors.
Sales to international customers amounted to $44.6 million and $35.9 million for 2006 and 2005, respectively. Since 2003, we have significantly expanded our direct sales and distribution operations outside of the United States in France, Germany, Belgium, Luxembourg, the United Kingdom, Italy, the Netherlands and Switzerland and we may expand these operations into additional countries in the future. Our accounts receivable balance for our international customers and distributors was $12.2 million and $9.0 million at December 31, 2006 and 2005, respectively. Specifically, our accounts receivable balances for our customers in Italy comprised 42% and 39% of accounts receivable from our international customers and distributors at December 31, 2006 and 2005, respectively. International customers and distributors generally demonstrate slower payment practices than those in the United States, increasing the risk of uncollectible accounts. Sales and costs resulting from our direct sales and distribution operations in Europe are denominated primarily in local currencies, including the Euro, and are subject to fluctuations in currency exchange rates. Further, we purchase our Triage Meter inventory from LRE and incur other operating expenses, including expenses related to clinical trials, which are denominated in Euros and other local currencies. Significant fluctuations in the currency exchange rates may negatively impact our consolidated sales and earnings.
International sales and operations are also subject to a variety of other risks, including:
· difficulty in staffing, monitoring and managing foreign operations;
· understanding of and compliance with local employment laws, including reduced flexibility and increased cost of staffing adjustments;
· unknown or changes in regulatory practices, including import or export license requirements, trade barriers, tariffs, employment and tax laws;
· adverse tax consequences, including imposition of withholding or other taxes on payments by subsidiaries;
· restrictions on repatriation of locally-derived revenue;
· competition from locally-produced products with cost advantages or national appeal;
· local business practices that could expose our direct sales and marketing organization to Foreign Corrupt Practices Act risks;
· political, social or economic conditions and changes in these foreign markets; and
· government spending patterns.
As a result, our operating results will fluctuate along with the currencies and general economic conditions in the countries in which we do business, which could harm our operating results.
We may need additional capital. If additional capital is not available, we may have to curtail or cease operations.
Our cash and marketable securities decreased from $132.4 million at December 31, 2005 to $64.2 million at December 31, 2006. During 2006, we repurchased $130.0 million of our common stock and we may repurchase additional shares in the future. If cash generated from operations is insufficient to satisfy our working capital and capital expenditure requirements, we may be required to sell additional equity or debt securities or obtain additional credit facilities. Additional capital, if needed, may not be available on satisfactory terms, or at all. Furthermore, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may include restrictive covenants. Our future liquidity and capital funding requirements will depend on numerous factors, including:
· the timing and amount of any additional repurchase of our stock;
· the scope, costs, timing and results of research and development efforts, including clinical studies and regulatory actions regarding our potential products;
· the extent to which our new products and products under development are successfully developed, gain regulatory approval and market acceptance and become and remain competitive;
· the costs, timing and effectiveness of further expansion of sales, marketing and manufacturing activities and resources;
· expansion of our manufacturing capacity and our facilities expansion needs, including the possible purchase of land adjacent to our San Diego corporate complex;
· the effects of competition, including products competitive with our Triage BNP Tests, from companies with greater financial capital and resources;
· the effect on sales and cash receipts for our Triage BNP Tests due to market saturation in the hospital market for natriuretic peptide testing in the United States;
· regulatory changes, uncertainties or delays;
· the impact of the prosecution, defense and resolution of potential future license and patent disputes;
· seasonal or unanticipated changes in customer demand;
· the timing and amount of any early retirement of our debt;
· changes in third-party reimbursement policies;
· the ability to execute, enforce and maintain license and collaborative agreements and attain the milestones under these agreements necessary to earn contract revenues; and
· the costs and timing associated with business development activities, including potential licensing of technologies patented by others.
If we require additional capital, and if we are not able to raise capital on acceptable terms when needed, we would have to scale back our operations, reduce our work force and license or sell to others products we would otherwise seek to develop or commercialize ourselves.
Healthcare reform and restrictions on reimbursement may adversely affect our results.
In the United States, healthcare providers that purchase our products and other diagnostic products generally rely on third-party payors to reimburse all or part of the cost of the procedure. In international markets, reimbursement and healthcare payment systems vary significantly by country, and include both government sponsored healthcare and private insurance. Third-party payors can affect the pricing or the relative attractiveness of our products by regulating the maximum amount of reimbursement provided by such payors for laboratory testing services. Third-party payors are increasingly scrutinizing and challenging the prices charged for both existing and new medical products and services. Lower than expected or decreases in reimbursement amounts for tests performed using our products may decrease amounts physicians and other practitioners are able to charge patients, which in turn may adversely affect our ability to sell our products to the physicians at prices we target. Third-party reimbursement and coverage may not be available or adequate in either U.S. or foreign markets, current reimbursement amounts may be decreased in the future and future legislation, regulation or reimbursement policies of third-party payors may adversely affect the demand for our products or our ability to sell our products on a profitable basis.
Failure to comply with government regulations regarding our products could harm our business.
Several state and federal laws have been applied to restrict certain marketing practices in the medical device industry in recent years. These include federal and state “anti-kickback” statutes. The federal health care program anti-kickback statute prohibits persons from knowingly and willfully offering, paying, soliciting, or receiving
remuneration in return for referrals or in return for purchasing, leasing, ordering, or arranging for or recommending purchasing, leasing, or ordering any service or item payable under Medicare, Medicaid, or certain other federally funded healthcare programs. These provisions have been broadly interpreted to apply to certain relationships between manufacturers, purchasers of manufacturers’ products, and parties in a position to refer or recommend purchases. Under current law, federal courts and the Office of Inspector General of the United States Department of Health and Human Services have stated that the statute may be violated if one purpose (as opposed to a primary or sole purpose) of remuneration is to induce prohibited purchases, recommendations or referrals.
There are a number of statutory exceptions and regulatory safe harbors under the federal anti-kickback statute, including those for properly disclosed reductions in price, payments to bona fide employees, payments to group purchasing organizations, compensation under personal services contracts and warranties. Although a failure to satisfy all of the criteria for a particular safe harbor does not necessarily mean that an arrangement is unlawful, practices that involve remuneration intended to induce purchases or recommendations may be subject to government scrutiny if they do not qualify for a safe harbor.
The majority of states also have statutes or regulations similar to the federal healthcare program anti-kickback statute. Certain of these laws do not have exemptions or safe harbors. Moreover, in several states, these laws apply regardless of whether payment for the services in question may be made under Medicaid or state health programs. Sanctions under these federal and state laws may include civil money penalties, license suspension or revocation, exclusion or medical product companies, providers, or practitioners from participation in federal or state healthcare programs, and criminal fines or imprisonment. Our practices may not in all cases meet all of the criteria for safe harbor protection from anti-kickback liability. Because of the breadth of these statutes, it is possible that some of our business activities could be subject to challenge under one or more of such laws. Such a challenge could have a material adverse effect on our business and financial condition.
Changing facilities costs and other risks relating to our facilities expansion plans may negatively impact our operating results.
In October 2003, we completed our purchase of approximately 26.1 usable acres of land for the construction of our new corporate complex. This land provides us with the potential for up to 800,000 square feet of space, to be constructed in phases as needed. The first phase, which is now complete, provides us with approximately 350,000 square feet of space. The total cost of the land and the construction of the first phase was approximately $110.0 million. We have relocated all of our operations to the new corporate complex. During 2006 we also acquired a facility in San Clemente, California to house our planned plastic molding operations. From time to time we will continue to evaluate the need to commence the next phase of construction of our corporate complex. We also will continue to evaluate the purchase of additional land or improved facilities to meet our future business needs. In particular, we have entered into an agreement under which we have an option to purchase an additional 17.2 usable acres of land adjacent to our corporate complex. Our occupancy costs have increased primarily due to increased square footage for our operations.
Should there be a downturn in our business or the markets in which we compete, we may not have a need to expand our facilities as we have planned. As a result, we may then seek an alternative use for all or a portion of some or all of our property, seek to sell some or all of our property and we may not exercise the option to purchase additional land adjacent to our corporate complex, any of which may have a negative impact on our operating results. We have, and may continue to experience unanticipated decreases in productivity and other losses due to inefficiencies relating to any such transition, or delays in obtaining any required approvals or clearances from regulatory agencies related to the validation of any new manufacturing facilities. For instance, the scale-up of manufacturing at our new corporate complex and in our planned molding facility has, and could continue to result in lower than expected manufacturing output and higher than expected product costs.
The San Diego Airport Authority has issued a draft of proposed changes to land uses, such as restrictions on maximum building heights, personnel densities and hazardous materials storage, in areas surrounding airports throughout San Diego County. Several of these changes, if approved, could potentially negatively impact our ability to construct our corporate complex as we currently plan. These changes could also impact the adjacent land that we have an option to purchase. In that case, we may need to alter our development plans for the remainder of our corporate complex. However, any such regulatory changes are still in the early stages and it is not possible for us to predict whether any changes will be adopted or implemented, and whether such changes could adversely impact our corporate complex.
Long-lived and intangible assets may become impaired and result in an impairment charge.
At December 31, 2006, we had approximately $181.0 million of long-lived assets, including $29.9 million of land, $82.5 million of buildings and improvements, $45.0 million of equipment, furniture and fixtures and $13.5 million of capitalized license rights and other assets. Buildings, building improvements, equipment, intangible assets and certain other long-lived assets are amortized or depreciated over their useful lives. In San Diego, we have one building lease that expires in February 2007. The carrying amounts of long-lived and intangible assets are affected whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Such events or changes might include a significant decline in market share, a significant decline in profits, rapid changes in technology, significant litigation or other matters. Adverse events or changes in circumstances may affect the estimated undiscounted future operating cash flows expected to be derived from long-lived and intangible assets. In the event impairment exists, an impairment charge would be determined by comparing the carrying amount of the asset to the applicable estimated future cash flows, discounted at a risk-adjusted interest rate. An impairment charge may result in a material adverse effect on our operating results. In addition, the remaining amortization period for the impaired asset would be reassessed and revised if necessary.
At December 31, 2006, we had approximately $13.1 million of short-term and long-term deferred tax assets, consisting primarily of temporary differences between book and tax treatment of certain items such as depreciation and stock-based compensation. No valuation allowance has been recorded to offset the deferred tax assets as we have determined that it is more likely than not that these assets will be realized. We will continue to assess the likelihood of realization of such assets; however, if future events occur which do not make the realization of such assets more likely than not, we will record a valuation allowance against all or a portion of the net deferred tax assets. Examples of future events that may occur which would make the realization of such assets unlikely would be a lack of taxable income resulting from poor operating results or rising tax deductions generated from disqualifying dispositions of shares issued under our stock plans.
We are dependent on others for the development of products. The failure of our collaborations to successfully develop products would harm our business.
Our business strategy includes entering into agreements with clinical and commercial collaborators and other third parties for the development, clinical evaluation and marketing of existing products and products under development. Many of the agreements are subject to rights of termination and may be terminated without our consent. These parties also may not abide by their contractual obligations to us and may discontinue or sell their current lines of business. Research performed under a collaboration for which we receive or provide funding may not lead to the development of products in the timeframe expected, or at all. If these agreements are terminated earlier than expected, or if third parties do not perform their obligations to us properly and on a timely basis, we may not be able to successfully develop new products as planned, or at all.
We may not be able to manage our growth, and we may experience constraints or inefficiencies caused by unanticipated acceleration and deceleration of customer demand.
If market acceptance of our products increases and potential new products are developed and commercialized, we may experience continued growth in the number of our employees, the scope of our operating and financial systems and the geographic area of our operations. Any such growth would result in an increase in responsibilities for both existing and new management personnel. Our ability to manage growth effectively, particularly in international markets, will require us to continue to implement and improve our operational, financial and management information systems and internal control, and to train, motivate and manage our employees. We may not be able to adequately manage our expansion, and a failure to do so could have a material adverse effect on us.
Unanticipated acceleration and deceleration of customer demand for our products has and may continue to result in constraints or inefficiencies related to our manufacturing, sales force, implementation resources and administrative infrastructure. Such constraints or inefficiencies may adversely affect us as a result of delays, lost potential product sales or loss of current or potential customers due to their dissatisfaction. Similarly, over-expansion or investments in anticipation of growth that does not materialize could harm our financial results and result in overcapacity. For instance, we have made non-cancelable purchase commitments for certain inventory and product components. Any such inventory or components that are not used when planned are subject to loss because of spoilage or obsolescence.
If we lose our key personnel or are unable to attract and retain additional personnel, we may not be able to manage our business, pursue collaborations or develop our own products.
Our future success depends in part on the continued service of our key technical, sales, marketing and executive personnel, and on our ability to identify, hire and retain qualified personnel. Competition for such personnel is intense and involves factors such as compensation, equity incentives, work culture, organization and direction. We may not be able to retain existing personnel or identify or hire additional personnel. We are currently actively recruiting for a significant number of key personnel for various positions in clinical and regulatory affairs. We are also recruiting for several vacancies in more senior positions within marketing and operations. If we are unable to retain existing personnel or identify or hire additional personnel, we may not be able to research, develop, commercialize or market our products as expected or on a timely basis, and as a result, our business may be harmed.
We may have significant clinical and product liability exposure.
The testing, manufacturing and marketing of medical diagnostic products entails an inherent risk of clinical and product liability claims. Our launch of new products, subject to obtaining appropriate regulatory approvals, to assist in the diagnosis of other indications, such as sepsis, acute kidney injury and stroke, may further increase our risk of these claims. Potential clinical and product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. In the future, our existing insurance may not be renewed at a cost and level of coverage comparable to that presently in effect, or at all. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the limits of our insurance coverage, our liabilities could exceed our total assets.
Future changes in financial accounting standards or practices or existing taxation rules or practices may cause adverse unexpected revenue and/or expense fluctuations and affect our reported results of operations.
A change in accounting standards or practices or a change in existing taxation rules or practices can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective. New accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements and taxation practice have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, as a result of changes approved by the Financial Accounting Standards Board, or FASB, on January 1, 2006 we began recording compensation expense in our statements of income for equity compensation instruments, including employee stock options, using the fair value method. Our reported financial results beginning for the first quarter of 2006 have been, and for all foreseeable future periods will be, negatively and materially impacted by this accounting change. Other potential changes in existing taxation rules related to stock options and other forms of equity compensation could also have a significant negative effect on our reported results.
Evolving regulation of corporate governance and public disclosure may result in additional expenses and continuing uncertainty.
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and we may be harmed.
Investor confidence and share value may be adversely impacted if our independent auditors are unable to provide us with the attestation of the adequacy of our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to include in our annual reports on Form 10-K a report of management on our internal controls over financial reporting, including an assessment by management of the effectiveness of those internal controls over financial reporting. In addition, our independent auditors must attest to and report on management’s assessment of the effectiveness of our internal controls over financial reporting. How companies are implementing these new requirements including internal control reforms, if any, to comply with Section 404’s requirements, and how independent auditors are applying these new requirements and testing companies’ internal controls, remain subject to some uncertainty. We expect that our internal controls will continue to evolve as our business activities change. Although we will continue to diligently and vigorously review our internal controls over financial reporting in order to ensure compliance with the Section 404 requirements, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. If, during any year, our independent auditors are not satisfied with our internal controls over financial reporting or the level at which these controls are documented, designed, operated, tested or assessed, or if the independent auditors interpret the applicable requirements, rules or regulations differently than we do, then they may decline to attest to management’s assessment or may issue a report that is qualified. This could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which could negatively impact the market price of our shares.
Item 1B.
Item 1B. Unresolved Staff Comments Not applicable.
Item 2.
Item 2. Properties We currently own approximately 26.1 usable acres of land for our corporate complex in San Diego, California. This land provides us with the potential for up to 800,000 square feet of space, to be constructed in phases as needed. The first phase, which is now complete, provides us with approximately 350,000 square feet of space. The total cost of the land and the construction of the first phase was approximately $110.0 million. We have relocated all of our operations to the new corporate complex.
In September 2006, we completed our purchase of a facility in San Clemente, California for $6.4 million. The facility is approximately 38,000 square feet and will be utilized to manufacture plastic parts for our diagnostic test kits. We are currently making improvements to the facility and installing new equipment needed for its operation. Pending the completion of those tasks and the recruitment and training of additional personnel, we expect manufacturing operations to commence at the San Clemente facility in the first half of 2007.
In December 2006, we entered into an agreement to lease approximately 17.2 acres of land adjacent to our current San Diego corporate complex. The lease is effective February 1, 2007 and expires in January 2012, subject to certain early termination rights. Under this agreement, in consideration for an annual non-refundable option payment of $500,000, we also have an option to purchase this property at any time between September 1, 2007 and August 31, 2009. If we elect to exercise the purchase option, the purchase price for the property will be equal to 97% of its fair market value at the time that we exercise the option, but in any event not more than approximately $33.7 million and not less than approximately $26.1 million, and any option payments will be applied to the final purchase price for the property.
We will continue to evaluate the potential purchase of this additional land or other improved facilities to meet our future business needs. In addition, from time to time we will continue to evaluate the need to commence the next phase of construction of our corporate complex. We expect our future occupancy costs to increase primarily due to increased square footage for our operations.
Should there be a downturn in our business or the markets in which we compete, we may not have a need to expand our facilities as we have planned. As a result, we may then seek an alternative use for all or a portion of some or all of our property, seek to sell some or all of our property and we may not exercise the option to purchase additional land adjacent to our corporate complex, any of which may have a negative impact on our operating results. We have, and may continue to experience unanticipated decreases in productivity and other losses due to inefficiencies relating to any such transition, or delays in obtaining any required approvals or clearances from regulatory agencies related to the validation of any new manufacturing facilities. For instance, the scale-up of manufacturing at our new corporate complex and in our planned molding facility has, and could continue to result in lower than expected manufacturing output and higher than expected product costs.
Internationally, we maintain the following offices, used for sales and/or marketing activities:
We also lease offices in Madrid, Spain and Hong Kong, China under short-term arrangements. Certain of the leases contain the right of early termination at Biosite’s sole discretion at specific dates during the applicable lease term. We believe our facilities are adequate for our current needs and that suitable additional or alternative space will be available in the future on commercially reasonable terms as needed.
Item 3.
Item 3. Legal Proceedings From time to time, we may be involved in litigation relating to claims arising out of our operations or incidental to the normal course of our business. As of the date of this Annual Report on Form 10-K, we are not engaged in any legal proceedings that may, individually or in the aggregate, have a material adverse effect on our business, financial condition or operating results.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders Not applicable.
PART II Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock is traded on the Nasdaq Global Select Market, under the symbol BSTE. The following tables set forth the high and low sale prices for our common stock as reported for the periods indicated.
There were approximately 85 holders of record of our common stock as of February 20, 2007. We have not paid any cash dividends to date and do not anticipate any being paid in the foreseeable future.
The information required to be disclosed by Item 201(d) of Regulation S-K, “Securities Authorized for Issuance Under Equity Compensation Plans,” is incorporated by reference within Item 12 of Part III of this Annual Report on Form 10-K.
Issuer Purchases of Equity Securities during the quarter ended December 31, 2006
Repurchases of Biosite Common Stock, par value $.01 per share
(1) In the fourth quarter of 2006, we paid Goldman, Sachs & Co. $100.0 million and received a substantial majority of the shares to be delivered under an accelerated stock repurchase agreement. The agreement includes collar provisions that establish the minimum and maximum numbers of shares to be repurchased. The specific number of shares to be repurchased is generally based on the volume-weighted average share price of our common shares during the six- to nine-month term of the accelerated stock repurchase agreement, subject to collar limits. During the quarter ended December 31, 2006, we repurchased an aggregate of 1,904,324 shares of our common stock at a total cost of approximately $100.0 million, including commissions. This represents the minimum number of shares that we will repurchase under the accelerated stock repurchase agreement. Repurchases under the program were made using our own cash reserves.
(2) Inclusive of commissions and costs.
(3) The average price per share reflects the maximum price under our accelerated stock repurchase agreement. The final price will not be known until we complete the program.
PERFORMANCE MEASUREMENT COMPARISON
This section is not “soliciting material” and shall not be deemed incorporated by reference by any general statement incorporating by reference this Proxy Statement into any filing under the Securities Act of 1933 or under the Securities Exchange Act of 1934, except to the extent the Company specifically incorporates this report by reference, and shall not otherwise be deemed filed under such Acts.
The following graph illustrates a comparison of the cumulative total stockholder return of the Company’s common stock with the Center for Research in Securities Prices Total Return Index for the Nasdaq Stock Market (U.S. and Foreign) (the “Nasdaq Composite Index”) and the Nasdaq Medical Devices, Instruments and Supplies, Manufacturers and Distributors Stocks Index (the “Nasdaq Medical Devices Index”) since December 31, 2001. The comparisons in the graph are required by the Securities and Exchange Commission and are not intended to forecast or be indicative of possible future performance of the Company’s common stock.
*Assumes a $100 investment on December 31, 2001 in each of the Company’s common stock, the securities comprising the Center for Research in Securities Prices Total Return Index for the Nasdaq Stock Market (U.S. and Foreign) and the securities comprising the Nasdaq Medical Devices, Instruments and Supplies, Manufacturers and Distributors Stocks Index (NMDI), including reinvestment of dividends.
Item 6.
Item 6. Selected Financial Data The following table sets forth selected consolidated financial data for each of our last five fiscal years during the period ended December 31, 2006. You should read this data in conjunction with Item 7, ”Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as with our consolidated financial statements and related notes appearing elsewhere in this Form 10-K.
(in thousands, except per share data)
(1) Computed on the basis described in Note 1 of our Notes to Consolidated Financial Statements.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The matters discussed in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contain forward-looking statements that involve risks and uncertainties. See “Forward-Looking Statements.”
Overview Founded in 1988, Biosite Incorporated is a global medical diagnostic company utilizing a biotechnology approach to create products for the diagnosis of critical diseases and conditions. Our primary business goal is to leverage our research and development advances and our installed base of existing customers to deliver first-in-class blood tests that provide diagnostic information not readily available to physicians treating acute diseases and conditions. To do this, we focus on validating, and patenting when possible, novel protein biomarkers and panels of biomarkers, manufacturing complex products at appreciable profit margins, conducting strategic clinical studies intended to validate our products’ diagnostic utilities and demonstrate favorable outcomes, and educating healthcare providers on the benefits of our diagnostic tests.
Our products are principally sold to acute care hospitals, which number approximately 5,100 in the United States. To market our products, we utilize a direct sales team that focuses its efforts primarily on larger centers with more than 200 beds and smaller hospitals that are high volume users of our products. We also use a network of distributors both in the United States and internationally. We also employ a field-based network of clinically experienced individuals that support our direct sales force by providing pre- and post- sale education and training.
Fisher distributes our products primarily in hospitals in the United States and supports our direct sales force, particularly in smaller hospitals. We have a distribution agreement with Fisher that extends through December 31, 2008, subject to some limited exceptions pursuant to which a party may elect to terminate the agreement earlier. Sales to Fisher represented 81% and 84% of our product sales in 2006 and 2005, respectively. We primarily utilize distributor relationships with Physician Sales & Services, or PSS, and Henry Schein, Inc., or Henry Schein, to market our products to physician office laboratories in the United States.
In international markets, we have established direct selling efforts in several European countries and utilize a network of country-specific and regional distributors in other areas. Since 2003, we have initiated direct sales and distribution operations in France, Germany, Belgium, Luxembourg, the United Kingdom, Italy, the Netherlands and Switzerland. In the future, we may transition to direct sales and distribution of our products in additional countries.
In 2006, we increased our direct sales force and field support staff dedicated to physician office laboratories to 23 individuals. We are currently evaluating further increases in our sales force and field support personnel dedicated to physician office laboratories in the United States as well as increases in such personnel dedicated to European markets. Depending on their cost and timing, we expect our sales, general and administrative expenses to increase in 2007 as a result of these increases in personnel.
Our total revenues for 2006 were $308.6 million, representing a 7% increase over 2005. While sales of our Triage BNP Test products have represented the largest portion of our historical product sales and the primary driver of our historical growth, during 2006 increased sales of our other cardiovascular products contributed significantly more than in past periods to our growth in product sales. Our meter-based Triage BNP Test, which is primarily used to aid in the diagnosis of heart failure, was launched domestically in January 2001. It was the first blood test available to aid in the detection of heart failure and benefited from a semi-exclusive position in the market, until the entry of direct competition in June 2003. In January 2004, we began marketing our Triage BNP Test for Beckman Coulter® Immunoassay Systems in the United States. As a result, a customer can perform b-type natriuretic peptide, or BNP, testing using either our rapid, portable Triage Meter system or any of Beckman Coulter Inc.’s automated immunoassay systems.
Today, our Triage BNP Test products are among several FDA-cleared blood products used to aid in the diagnosis of heart failure. These include products from Siemens, Dade Behring, Roche Diagnostics, Abbott Laboratories and Ortho Clinical Diagnostics, which offer products based on large, centralized automated testing platforms. In addition, Abbott Laboratories now offers a BNP test on its i-STAT meter product, which is designed for use at the point-of-care. In January 2007, GE announced that it entered into a definitive agreement to purchase the laboratory diagnostics business of Abbott Laboratories, including Abbott’s i-STAT product line. We have experienced, and continue to experience, competition from these companies and anticipate competition from others in the future. Our
competitors may succeed in developing or marketing products that are more effective or more commercially attractive than the Triage BNP Tests. Moreover, we may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully with these and other competitors in the future.
With several diagnostic products commercialized, our focus has expanded to include the search for proprietary disease biomarkers that can potentially be applied to our testing platforms or to platforms marketed by other diagnostic companies with whom we might collaborate. To that end, in 1999 we launched Biosite Discovery, a research program. Through Biosite Discovery, we leverage our expertise in phage display antibody development to access protein targets via collaborations with clinical institutions or commercial companies, or via our internal research and licensing programs. Biosite Discovery has also attracted the interest of leading clinical collaborators, who provide patient samples and assist in the analysis of clinical data. The discovery of new disease markers and the extension of applications for existing products could enable us to expand our product sales into other healthcare market segments.
We have reported consecutive quarterly operating profits since the third quarter of 1999, after incurring quarterly operating losses during the prior seven quarters. Our operating results may fluctuate on a quarterly or annual basis in the future and our growth or operating results may not be consistent with predictions made by securities analysts. We may not be able to maintain profitability in the future. Some of the risks and uncertainties associated with our business and future operating results are discussed below under the heading “Liquidity and Capital Resources,” and in Item 1A, “Risk Factors” of this Annual Report on Form 10-K.
Critical Accounting Policies Involving Management Estimates and Assumptions
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying financial statements and related footnotes. In preparing these financial statements, management has made its best estimates and judgments of certain amounts included in the financial statements, giving due consideration to materiality. We do not believe there is a great likelihood that materially different amounts would be reported related to the accounting policies described below. However, application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. Our senior management has discussed the development and selection of the critical accounting estimates, and related disclosures, with the Audit Committee of our Board of Directors.
Revenue Recognition. We recognize product sales upon shipment, including to Fisher and our other distributors, unless there are significant post-delivery obligations or collection is not considered probable at the time of shipment. Generally, we do not have any significant post-delivery obligations associated with our product sales and our credit losses have been minimal. We record an estimate of end-user sales rebates as a reduction of product sales at the time of shipment. The sales rebates are primarily earned by the customer under a contract, payable by us at a specified rate and are based on an estimate of the customer’s attainment of a specified minimum purchase level for a specified product over a stated period of time. We do monitor inventory levels of our products at Fisher and historically, those levels have been, on average, approximately one month or less.
Our collaborative development agreements generally contain specific payments for specific activities or elements of the agreements. Among the payments we might receive under the agreements are: up-front technology access fees, research funding, antibody development fees upon the delivery of antibodies, annual maintenance fees on targets for which we have produced antibodies for as long as the targets remain in development by our collaborators, milestone fees on drug targets that reach certain development milestones and royalties should products successfully be commercialized as a result of the collaboration. Up-front technology access fees are recognized over the term of the agreement or ongoing research period, as applicable, unless we have no further continuing performance obligations related to the fees. Research funding is recognized over the applicable research period on a straight-line basis, which approximates the underlying performance. Milestone payments, such as antibody development fees and clinical milestones, are recognized when earned, as the milestone events are substantive and their achievability is not reasonably assured at the inception of the agreement. Contract revenues that are based on the performance of and collection by our collaborators or their partners are deferred until such performance is complete and collection is probable. We believe that each payment element of these agreements represents the fair value of the element at the date of the agreement.
The SEC’s Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, provides guidance on the application of generally accepted accounting principles to selected revenue recognition issues. We believe that our
revenue recognition policy is appropriate and in accordance with generally accepted accounting principles and SAB No. 104.
Allowance for Doubtful Accounts. We also maintain an allowance for doubtful accounts for potential uncollectible accounts receivable arising from our customers’ inability to make required payments. Our estimate is determined by analyzing historical bad debts, customer payment history and patterns, customer creditworthiness, and economic, political or regulatory factors affecting the customer’s ability to make the required payments.
Inventories and Related Allowances. Net inventories are valued at the lower of the first-in, first-out, or FIFO, cost or market value and have been reduced by an allowance for excess, obsolete and potential scrap inventories. The estimated allowance for excess, obsolete and potential scrap inventories is based on inventories on hand compared to estimated future usage and sales, and assumptions about the likelihood of scrap or obsolescence. During our manufacturing processes, some work-in-process inventories require additional testing or re-work to meet technical specifications. These inventories are tracked using a specific identification method and reviewed on a monthly basis to determine their status and an estimated reserve for potential scrap is calculated. Our estimates for potential scrap for these inventories may change as further testing and re-work is performed. If actual scrap is different from our estimates, revisions to the scrap reserve would be required at the time of such determination and could positively or negatively affect our reported operating results.
We regularly review inventory quantities on hand and record an allowance for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements for the next two to five years. Future events or factors may affect the net realizable value of our inventories and our estimates and assumptions used to determine our allowance for excess, obsolete and potential scrap inventories. Such events or factors include manufacturing quality, unanticipated acceleration or deceleration of product demand, changes in technology or production methods and new product development. These factors could result in an increase or decrease of our estimates of excess, obsolete or potential scrap inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the allowance required for excess, obsolete and potential scrap inventory. In the future, if we determine that the estimated net realizable value of our inventory may be overstated, we will record such reduction in value as additional cost of sales at the time of such determination. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated change in demand or technological development could have a significant impact on the value of our inventory and our reported operating results.
We utilize a standard cost system to track our inventories on a part-by-part basis. When necessary, adjustments are made to the standard materials, standard labor and standard overhead costs to approximate actual labor and actual overhead costs on a FIFO cost basis.
Income Tax Reserve. It is our policy to record tax benefits only if we conclude that it is at least probable that the deduction or credit will be sustained upon examination by tax authorities. In the period that permanent tax benefits, including research and development tax credits, are generated, we recognize the tax benefits at their estimated net realizable value. With regard to research tax credits, the determination of qualified expenses and activities involves judgment. Tax authorities have regularly examined and challenged research and development tax credits claimed by companies and have disallowed tax credit amounts based on the tax authorities’ evaluation and judgment. We reduce tax benefits to their estimated net realizable value based upon our management’s assessment of exposure associated with permanent tax differences, tax credits and interest expense applied to temporary difference adjustments. The tax benefits are analyzed periodically and adjustments are made as events occur to warrant adjustments to the estimate of the net realizable value of the tax benefits.
During the first quarter of 2006, the Internal Revenue Service, or IRS, completed its field audit of our federal income tax returns for all years through December 31, 2004. Based on the results of the examination, we decreased previously recorded tax contingency reserves by approximately $1.2 million, of which $891,000 favorably impacted our tax provision for the quarter ended March 31, 2006 and $340,000 was recorded as an increase to our paid-in capital.
During the fourth quarter of 2006, the California Franchise Tax Board completed its field audit of our state income tax returns for all years through December 31, 2003. Based on the results of the examination, we decreased previously recorded tax contingency reserves by approximately $980,000, all of which favorably impacted our tax provision for the quarter ended December 31, 2006.
Stock-based Compensation. With respect to accounting for stock-based compensation related to our employees for periods through December 31, 2005, we followed Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and related interpretations. During these periods, stock options issued to non-employees were recorded at their fair value as determined in accordance with FAS No. 123, Accounting for Stock-based Compensation, or FAS 123, and Emerging Issues Task Force, or EITF, Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and were periodically remeasured as the stock options vested. Beginning January 1, 2006, we adopted FAS No. 123 (revised 2004), a revision to FASB Statement No. 123, or FAS 123(R). FAS 123(R) did not have an impact on the accounting for stock options granted to non-employees.
Under FAS 123(R), stock-based compensation cost is measured at the grant date, based upon the estimated fair value of the award, and is recognized as compensation expense over the employee’s requisite service period. We adopted the provisions of FAS 123(R) on January 1, 2006 using the modified prospective method, which provides for certain changes to the method for valuing stock-based compensation. Under the modified prospective method, prior periods are not revised for comparative purposes. The valuation provisions of FAS 123(R) apply both to new stock-based awards and to awards that are outstanding on January 1, 2006 but are subsequently modified or cancelled. Estimated compensation expense for awards outstanding at January 1, 2006 is recognized over the remaining service period using the compensation cost calculated for pro forma purposes under FAS 123. Included in the disclosures to the accompanying financial statements is information regarding our share-based payment valuation methodology, the significant assumptions used in our valuation models, our estimated stock-based compensation, and its effect on our net income and net income per share as required by FAS No. 123(R).
For all stock options granted on or after April 1, 2005, we changed our valuation model from the Black-Scholes model to the Aon Actuarial Binomial Model, which was provided by Aon Consulting. The fair value of stock options and purchase rights granted prior to April 1, 2005 was determined using the Black-Scholes model. We believe that the binomial model considers characteristics of fair value option pricing that are not available under the Black-Scholes model. Similar to the Black-Scholes model, the binomial model takes into account variables such as volatility, dividend yield rate and risk-free interest rate. However, in addition, the binomial model considers the contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life, and the probability of termination or retirement of the option holder in computing the value of the option.
The valuation of our share-based payment such as stock options and stock purchase rights under our ESPP is determined at the date of grant using the Aon Actuarial Binomial Model and Black-Scholes model, both of which utilize variables based on certain input assumptions. These variables include, but are not limited to: 1) expected term or life of our share-based awards, 2) expected volatility of our stock price during the expected lives of our share-based awards, 3) expected dividends during the expected life, and 4) the risk-free interest rate.
Estimating the fair value of share-based payments is highly dependent on assumptions regarding the future exercise behavior of our employees and the changing price of our publicly traded common stock. Our share-based payments have characteristics significantly different from those of exchange-traded options, and changes in the subjective input assumptions of our share-based payment valuation models can result in materially different estimates of the fair values of our share-based payments. Additionally, the actual values realized upon the exercise of the award, the exercise behavior of the holder of the share-based award, early termination or forfeiture of share-based awards may be significantly different than our assumptions used to determine the estimated fair values of those awards as determined at the date of grant.
There are significant differences among valuation models, methods and assumptions that companies employ, and there is a possibility that we will adopt different valuation models, methods and assumptions in the future. This may result in a lack of consistency in future periods and may materially affect our fair value estimate of stock-based payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.
For purposes of estimating the fair value of stock options granted during 2006 using the Aon Actuarial Binomial Model, we have made an estimate using subjective assumptions regarding our expected stock price volatility (weighted average of 46%). We estimate the expected volatility of our stock options at their grant date, placing equal weighting on the historical volatility and the implied volatility of our stock. If our stock price volatility assumption for the stock options granted during 2006 was increased by 10% to 56%, the weighted average estimated fair value of stock options granted during that period would increase by $2.97 per share, or 14.1%.
Our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, values may be realized from these instruments that are significantly in excess of the fair values originally estimated on the grant date and reported in our financial statements. Although the fair value of our employee stock-based awards is determined in accordance with FAS 123(R) and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 (SAB 107) using valuation models, that calculated value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
Recent Developments
None
Results of Operations
Years ended December 31, 2006 and 2005
Product Sales. Product sales by product family were as follows (in thousands):
Product Sales. Product sales for 2006 were $303.3 million, representing an increase of 7% compared to $282.8 million for 2005. The $20.5 million increase in total product sales consisted primarily of product sales growth resulting from an increase in sales volume of $29.9 million, partially offset by a decrease in product sales resulting from lower average selling prices of approximately $9.4 million. In 2006, growth in the sales volume of our Triage BNP Tests represented 41% of the product sales growth resulting from an increase in sales volume. By comparison, in 2005, growth in the sales volume of our Triage BNP Tests represented 69% of the product sales growth resulting from an increase in sales volume.
Primarily as a result of significant fluctuations in customer demand, inventory levels of our products have been, and in the future may be, below or above targeted stocking levels. We adjust our manufacturing output by both adjusting our production activities and the number of production shifts we operate, as well as by implementing additional manufacturing equipment. This allows us to modify our production volumes and manufacturing throughput to meet expected customer demand and targeted stocking levels. Our product sales are also impacted by the buying patterns of our distributors and other customers. Additionally, we believe that our products are subject to some seasonality in their use. Higher utilization rates of our Triage BNP Tests may be due to a higher number of emergency department, or ED, visits by patients exhibiting shortness of breath, a symptom of heart failure and of influenza. However, higher utilization may also result from greater awareness, education and acceptance of the uses of our Triage BNP Test products, as well as from an increase in the number of users within the hospitals. Product sales to our distributors in future periods will be impacted as we and our distributors attempt to adjust our distributors’ inventories to targeted stocking levels and as we seek to improve our effectiveness and efficiency in adjusting our manufacturing output.
Product sales of our cardiovascular products, consisting of our Triage BNP Tests, Triage Cardiac Panel, Triage CardioProfiler Panel, Triage Profiler Shortness of Breath Panel, Triage D-Dimer Test, and Triage Stroke Panel, totaled $251.3 million for 2006. This represented an increase of 10% as compared to product sales of $229.2 million for 2005. For 2006, the product sales growth of our cardiovascular products was primarily due to growth in sales unit volume of our Triage BNP Tests of $12.2 million and our Triage Profiler Panels of $11.2 million. This increase was partially offset by a reduction in product sales due to a decline in the average sales price of our Triage BNP Tests of $5.4 million.
Our product sales growth rate for our Triage BNP Tests in future periods may be lower than in past periods because of increased competition from alternative tests and testing platforms that aid in the diagnosis of heart
failure. In addition, because most U.S. hospitals are already performing some form of testing for natriuretic peptides, the sales growth for our Triage BNP Tests resulting from the addition of new hospital customers in the United States may be less than what we have experienced in the past. Furthermore, as the global market for BNP testing matures and more competitive products become available, we anticipate that the average sales price for our Triage BNP Tests will continue to decline, which would negatively impact our revenue from product sales.
Product sales of the Triage Drugs of Abuse Panel, Triage TOX Drug Screen, Triage C. difficile Panel, Triage Parasite Panel and Triage Meter, were $52.0 million and $53.6 million for 2006 and 2005, respectively, representing a decrease of 3%. The decrease in sales of these products was primarily due to decreases in sales of the Triage Drugs of Abuse Panel of $5.1 million and Triage Meter of $507,000 for 2006, compared with 2005. The decrease was partially offset by growth in sales of our Triage TOX Drug Screen of $4.3 million, compared with 2005. We believe that domestic sales of the Triage Drugs of Abuse Panel products may continue to decline as the available U.S. hospital market becomes saturated and competitive pressures become more prominent in a maturing market.
Contract Revenues. Contract revenues consist of revenues associated with our research and development and licensing arrangements, including license fees, milestone revenues, royalties, research funding and antibody fees. Contract revenues for 2006 were $5.3 million, compared to $4.9 million for 2005.
Contract revenues recognized during 2006 and 2005 consisted primarily of research funding. During both 2006 and 2005, we recognized $3.0 million of research funding from an alliance with Medarex Inc., which expires in May 2008. The increase in contract revenues for 2006 as compared to 2005 was primarily related to an increase in funding for research and development services performed of $820,000. The increase was partially offset by a $600,000 decrease in annual maintenance fees on antibodies produced by Biosite that are used in research and development programs of our partners. Biosite Discovery activities are performed and its costs are incurred by certain of our research and development teams. These Biosite Discovery research and development resources concurrently focus on programs for our partners, which generate our contract revenues, and on internal research and development programs. Costs of the research and development resources performing collaborative and internal Biosite Discovery activities were $8.9 million for 2006, compared to $8.0 million for 2005. These costs are included in research and development expenses. If we are unable to renew or enter into research alliances, we expect a decrease in contract revenues in 2008 primarily due to the expiration of our agreement with Medarex.
Cost of Product Sales and Gross Profit From Product Sales. Gross profit from product sales for 2006 was $209.0 million, representing an increase of 6% compared to $197.7 million for 2005. The $11.3 million increase in gross profit from product sales in 2006, compared to 2005, consisted of $14.3 million attributable to product sales growth, partially offset by a $3.0 million decrease resulting from changes in the gross margins of our different products. The overall gross margin for 2006 decreased to 69%, compared to 70% for 2005. The decrease in the overall gross margin for 2006 as compared to 2005 was primarily due to a $2.7 million increase in stock-based compensation expense.
We expect our overall gross margin to fluctuate in future periods as a result of the changing mix of products sold with different gross margins, changes in our manufacturing processes or costs, and competitive pricing pressures. Any new products that we successfully develop, acquire and sell may change our future gross margins. Manufacturing inefficiencies, including inefficiencies experienced as we attempt to manufacture newer products on a larger scale, adjust to our new manufacturing facilities and an increase or decrease in our manufacturing capacity, production volumes and manufacturing output, will also impact our gross margins. We have recently made significant investments in facilities, equipment and technology for new programs designed to develop internal capabilities to manufacture certain product components that we currently purchase through vendors. These investments could adversely impact our gross profit in the future if planned efficiencies are not attained. Our manufacturing overhead costs are spread over the changing production volumes manufactured during a quarter on a first-in, first-out basis.
We expect our cost of product sales in 2007 to be higher than 2006 as we anticipate that our fixed occupancy costs, including depreciation expense, will increase because our manufacturing operations at our new corporate complex occupy a much larger space than in our previous manufacturing facilities, and because of our purchase of a new facility to house our future in-house production of certain plastic components of our products. We have experienced, and may continue to experience, unanticipated decreases in productivity and other losses due to inefficiencies relating to these activities. For instance, the scale-up of manufacturing at our new corporate complex has resulted, and could continue to result in lower than expected manufacturing output and higher than expected product costs. In addition, we are incurring expenses relating to the scale-up of our plastic injection molding facility, which is not currently operational.
Selling, General and Administrative Expenses. Selling, general and administrative, or SG&A, expenses increased 30% to $97.1 million for 2006, from $74.8 million for 2005. At December 31, 2006, our headcount for SG&A functions totaled 384 employees, compared with 350 at December 31, 2005. The increase in SG&A expenses for 2006 consisted primarily of $15.1 million in stock-based compensation expense. Also, as a result of growth in sales activities, marketing activities and general administrative resources for 2006, employee-related expenses, excluding stock-based compensation, increased approximately $2.8 million in 2006, as compared to 2005. Our facilities expenses related to SG&A activities also increased by $1.8 million in 2006, as compared to 2005, primarily due to costs related to the move from our previous facilities to our new corporate complex.
We expect SG&A expenses to increase in 2007 as compared to 2006 as we continue to increase our sales, marketing, clinical education, technical service and general administration resources, to address the physician office laboratories market in the United States, and as we continue to build our direct sales, distribution and administrative infrastructure in Europe. We also expect other non-employee-related costs, including sales and marketing program activities for our new products, to grow as our overall operations grow. The timing of these increased expenditures and their magnitude are primarily dependent on the commercial success and sales growth of our products as well as on the timing of any new product launches and our assessment of resources to address new market segments such as physician offices. We expect our expense for stock-based payments, such as stock options, to decrease in 2007 as compared to 2006.
Research and Development Expenses. Research and development, or R&D, expenses increased 26% to $53.0 million for 2006 from $42.2 million for 2005. The increase in R&D expenses for 2006 consisted primarily of an increase in stock-based compensation expense of $7.0 million, an increase in equipment related expenses, including depreciation, of $1.1 million, and an increase in expenses for supplies used in our R&D activities of $971,000. During 2006, our R&D resources were focused primarily on product development for potential new diagnostic products, including a new panel for acute coronary syndrome, or ACS, and on other diagnostic products for critical health conditions such as sepsis and acute kidney injury. We also focused on the development of potential improvements to our existing products, including our Triage Cardiac Panel, manufacturing processes and research activities associated with Biosite Discovery. Expenses related to the performance of our obligations associated with earning our contract revenues were incurred by our R&D group and were primarily related to Biosite Discovery.
We expect R&D expenses in 2007 to be higher than in 2006 and to relate primarily to:
· product development efforts, including the development of potential products for ACS, sepsis, acute kidney injury and stroke;
· clinical studies, including studies associated with potential products for sepsis, acute kidney injury, stroke and chest pain and studies related to the exploration and validation of other potential uses for our Triage BNP Tests, as well as the continuing development of our infrastructure to address our increasing clinical study activities;
· engineering development programs intended to automate and improve manufacturing processes and improve the Triage Meter Platform;
· manufacturing scale-up for potential new products;
· costs associated with FDA submissions for products under development and other interactions with the FDA;
· Biosite Discovery activities; and
· performance-based cash compensation.
The timing of such increased expenditures and their magnitude are primarily dependent on the timing and progress of our R&D efforts, which are subject to a variety of risks and uncertainties. For instance, the number, size, duration and complexity of our clinical studies has increased and we expect will continue to increase significantly in 2007. Conducting clinical studies is a complex, time-consuming and expensive process. The length of time, number of study sites and patients required for clinical studies vary substantially according to the type, complexity, novelty and intended use of the potential product, and therefore, we may spend as much as several years completing certain studies. We estimate our clinical trial expenses, including internal and external costs, will be approximately $7.0 million to $9.0 million in 2007.
Our R&D resources are organized and evaluated by functional areas. Each of these areas works simultaneously on multiple R&D projects. We track our R&D expenses by those functional areas and we have not tracked our R&D spending on a project-by-project or product-by-product basis. We do not track all of our R&D expenditures by individual projects and products because many of the costs and activities benefit multiple R&D projects and products.
License and Patent Disputes. Expenses associated with license and patent disputes were $3.1 million for 2006, compared to $2.0 million in 2005. In 2006, these expenses consisted primarily of a $2.9 million portion of the $8.5 million settlement payment related to our litigation with Roche Diagnostics Corporation and its affiliates, which was recognized in 2006.
In November 2004, Roche Diagnostics Corporation, together with certain of its affiliates, filed a complaint in the United States District Court, Southern District of Indiana, Indianapolis Division alleging that we were infringing two patents, U.S. Patent 5,366,609 and U.S. Patent 4,816,224, owned by Roche and/or its affiliates (the “Indiana Case”). Also, in November 2004, we filed a complaint in the United States District Court, Southern District of California alleging that Roche Diagnostics Corporation and Roche Diagnostics GmbH were infringing two patents, U.S. Patent 6,174,686 and U.S. Patent 5,795,725, owned by us. We later amended our complaint to also allege infringement of one additional patent owned by us, U.S. Patent 6,939,678 (the “California Case”).
In July 2006, we and Roche entered into an agreement to settle both the Indiana Case and the California Case. The settlement involves a worldwide, royalty-free, non-exclusive cross-license of the patents involved in the two cases. Under the terms of the settlement agreement, we and Roche dismissed our respective complaints in the Indiana Case and the California Case. We made a one-time license payment of $8.5 million to Roche. Of the $8.5 million license payment, $2.9 million was recognized in the second quarter of 2006 as license amortization expense related to prior periods and charged to license and patent disputes. The remaining $5.6 million was capitalized as the cost of the license and will be amortized to cost of product sales over the remaining life of the Roche patents, the last of which expires in June 2013. We expect our license and patent dispute expenses to decrease in 2007 as compared to 2006.
Interest and Other Income, Net. Interest and other income, net was $4.2 million for 2006, compared to $2.7 million for 2005. The increase for 2006 resulted primarily from increases in interest income of approximately $1.6 million, due to higher average balances of cash and marketable securities and higher interest rates compared to 2005. The increase during 2006 was also partially attributable to net unrealized gains on receivables and payables denominated in foreign currencies of $257,000, compared with net unrealized losses of $207,000 in 2005. The increase was partially offset by additional interest expense of $557,000 for 2006 as compared to 2005.
We expect interest and other income for 2007 to be lower than 2006 due to lower average balances of cash and marketable securities compared to 2006.
Provision for Income Taxes. Primarily as a result of the amount of estimated pre-tax income and the estimated tax credits and other permanent differences between our reported and taxable income in 2006, such as differences related to stock-based compensation, we recorded a provision for income taxes of $25.3 million for 2006, equivalent to an effective tax rate of 38.8%. For 2005, we recorded a provision for income taxes of $32.3 million, equivalent to an effective tax rate of 37.4%. The increase in the effective tax rate is primarily due to the effect of the adoption of FAS 123(R). The increase was offset by a 2.8% decrease in the rate resulting from the release of tax reserves upon finalization of federal and California tax audits.
During the first quarter of 2006, the IRS completed its field audit of our federal income tax returns for all years through December 31, 2004. Based on the results of the examination, we decreased previously recorded tax contingency reserves by approximately $1.2 million, of which $891,000 favorably impacted our tax provision for the quarter ended March 31, 2006 and $340,000 was recorded as an increase to our paid-in capital.
During the fourth quarter of 2006, the California Franchise Tax Board completed its field audit of our state income tax returns for all years through December 31, 2003. Based on the results of the examination, we decreased previously recorded tax contingency reserves by approximately $980,000, all of which impacted our tax provision for the quarter ended December 31, 2006.
We are subject to audits by federal, state, local, and foreign tax authorities. We believe that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. Should any issues addressed in our tax audits be resolved in a manner not consistent with management’s expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. We will continue to assess the likelihood of realization of our tax credits and other net deferred tax assets. If future events occur that do not make the realization of such assets more likely than not, a valuation allowance will be established against all or a portion of the net deferred tax assets.
Stock-Based Compensation. On January 1, 2006, we adopted FAS 123(R), Share-Based Payment, which requires that we record compensation expense in the statement of income for stock-based payments, such as employee stock options, using the fair value method. The valuation provisions of FAS 123(R) apply to new awards and to awards that were outstanding on January 1, 2006 and are subsequently modified or cancelled. Under the modified prospective method, financial statements for prior periods are not revised for comparative purposes. For the year ended December 31, 2006, we recorded compensation expense totaling $24.9 million, and we recorded $7.2 million of tax benefits associated with the compensation expense and the disqualifying disposition of incentive stock options and stock purchase rights occurring during the same periods. The net impact of our adoption of FAS 123(R) was to reduce our diluted earnings per share by $1.01 for 2006, after consideration of the impact of FAS 123(R) on the number of diluted shares used in the calculation. The stock-based compensation was recorded as part of employee expenses within each of the components of our operating expenses and tax provision during 2006 as follows:
(in thousands, except per share data)
The requirements of FAS 123(R), including the recording of stock-based compensation expense, tax benefits or expense related to share-based awards and changes to the calculation of diluted shares used in computation of earnings per share, have had and will continue to have a material effect on our financial results reported under U.S. GAAP. As of December 31, 2006, there was $32.6 million of unrecognized compensation cost related to outstanding stock options that is expected to be recognized as a component of our operating expenses over a weighted-average period of 2.5 years, and there was $2.1 million of unrecognized compensation cost related to outstanding employee stock purchase plan, or ESPP, rights that is expected to be recognized over a weighted-average period of 8.1 months. The issuance of new share-based awards will further impact our future financial results. However, such share-based payments will never result in the payment of cash by us. For this reason, and because we do not view stock-based compensation as related to our operational performance, we exclude the stock-based compensation expense when we evaluate our financial and business performance, including for internal resource management, planning and forecasting purposes.
The determination of the fair value of our share-based awards is performed on the date of grant using valuation models such as the Aon Actuarial Binomial Model, which was provided by Aon Consulting, and the Black-Scholes model. Both of these valuation models utilize a number of complex variables and require assumptions regarding the future. These variables and assumptions include, but are not limited to, our expected volatility of our stock price over the expected term of the awards, the expected term of the awards, the expected dividend rate and the risk-free interest rate.
Estimating the fair value of share-based payments is highly dependent on assumptions regarding the future exercise behavior of our employees and the changing price of our publicly traded common stock. Our share-based payments have characteristics significantly different from those of exchange-traded options, and changes to the subjective input assumptions of our share-based payment valuation models can result in materially different estimates of the fair values of our share-based payments. Additionally, the actual values realized upon the exercise of the award, the exercise behavior of the holder of the share-based award, early termination or forfeiture of share-based award may be significantly different than our assumptions used to determine the estimated fair values of those awards as determined at the date of grant.
There are significant differences among valuation models, methods and assumptions that companies employ, and there is a possibility that we will adopt different valuation models, methods and assumptions in the future. This may result in a lack of consistency in future periods and may materially affect our fair value estimate of stock-based
payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.
For purposes of estimating the fair value of stock options granted during 2006 using the Aon Actuarial Binomial Model, we have made an estimate using subjective assumptions regarding our expected stock price volatility (weighted average of 46%). We estimate the expected volatility of our stock options at their grant date, placing equal weighting on the historical volatility and the implied volatility of our stock. If our stock price volatility assumption for the stock options granted during 2006 was increased by 10% to 56%, the weighted average estimated fair value of stock options granted during that period would increase by $2.97 per share, or 14.1%.
Our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, values may be realized from these instruments that are significantly in excess of the fair values originally estimated on the grant date and reported in our financial statements. Although the fair value of our employee stock-based awards is determined in accordance with FAS 123(R) and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 (SAB 107) using valuation models, that calculated value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
Years ended December 31, 2005 and 2004
Product Sales. Product sales for 2005 were $282.8 million, representing an increase of 18% compared to $240.6 million for 2004. The $42.2 million increase in total product sales consisted primarily of product sales growth resulting from an increase in sales volume of $46.7 million, partially offset by a decrease in product sales resulting from lower average selling prices of approximately $4.5 million. In 2005, growth in the sales volume of our Triage BNP Tests represented 69% of the product sales growth resulting from an increase in sales volume. By comparison, in 2004, growth in the sales volume of our Triage BNP Tests represented 85% of the product sales growth resulting from an increase in sales volume.
Product sales of our cardiovascular products, consisting of our Triage BNP Tests, Triage Cardiac Panel, Triage CardioProfiler Panel, Triage Profiler Shortness of Breath Panel and Triage D-Dimer Test totaled $231.9 million for 2005. This represented an increase of 20% as compared to $192.5 million for 2004. The product sales growth of our cardiovascular products was primarily due to growth in sales volume of our Triage BNP Tests of $32.3 million, and of our Triage Profiler Panels of $9.0 million. This increase was partially offset by a reduction in product sales due to a decline in the average sales price of our Triage BNP Tests of $4.7 million.
Product sales of the Triage Drugs of Abuse Panel, Triage TOX Drug Screen, Triage C. difficile Panel, Triage Parasite Panel and Triage Meter were $50.9 million for 2005. This represented an increase of 6% as compared to $48.1 million for 2004. The increase in sales of these products for 2005 was primarily due to the growth in sales volume of our Triage TOX Drug Screen of $4.3 million. The increase was partially offset by a decrease in sales volume of the Triage Drugs of Abuse Panel of $2.6 million.
Contract Revenues. Contract revenues for 2005 were $4.9 million, compared to $4.3 million for 2004. Contract revenues recognized during 2005 and 2004 consisted primarily of research funding. During both 2005 and 2004, we recognized $3.0 million of research funding from Medarex. The increase in contract revenues for 2005 as compared to 2004 was related to an increase of $900,000 in annual maintenance fees on antibodies produced by Biosite that are used in research and development programs of our partners. The increase was partially offset by a $250,000 decrease in research milestone payments. Biosite Discovery activities are performed and its costs are incurred by certain of our research and development teams. These Biosite Discovery research and development resources concurrently focus on programs for our partners, which generate our contract revenues, and on internal research and development programs. Costs of the research and development resources performing collaborative and internal Biosite Discovery activities were $8.0 million for 2005, compared to $6.5 million for 2004. These costs are included in research and development expenses.
Cost of Product Sales and Gross Profit From Product Sales. Gross profit from product sales for 2005 was $197.7 million, representing an increase of 23% compared to $161.2 million for 2004. The $36.5 million increase in gross profit from product sales in 2005, compared to 2004, consisted of $28.3 million attributable to product sales growth and $8.2 million resulting from changes in the gross margins of our different products. The overall gross
margin for 2005 increased to 70%, compared to 67% for 2004. The increase in the overall gross margin was primarily due to operational improvements that resulted in greater manufacturing efficiencies and lower scrap.
Selling, General and Administrative Expenses. SG&A expenses for 2005 were $74.8 million, representing an increase of 14%, compared to $65.4 million for 2004. At December 31, 2005, our headcount for SG&A functions totaled 350 employees, compared with 315 employees at December 31, 2004. The increase in SG&A expenses was primarily associated with the addition of sales, clinical education and technical service resources, and administrative support. The expansion of our direct sales, marketing and distribution operations in Europe resulted in increases in SG&A expenses of $3.6 million in 2005 as compared to 2004. Our facilities expenses related to SG&A activities increased by approximately $2.4 million in 2005, as compared to 2004, primarily due to costs related to the relocation to our new corporate complex in 2005. Also, as a result of growth in sales activities, marketing activities and general administrative resources for 2005, employee-related expenses in the United States increased approximately $2.2 million as compared to 2004.
Research and Development Expenses. R&D expenses for 2005 were $42.2 million, representing an increase of approximately 18% compared to $35.7 million for 2004. The increase in R&D expenses for 2005 consisted primarily of an increase in employee expenses of $2.9 million. Additionally, for 2005, we experienced increases in consultant, clinical studies and patent-related expenses of $1.9 million and increases in facilities costs of $611,000 as compared to 2004. During 2005, our R&D resources were focused primarily on product development for potential new diagnostic products, including a new ACS panel and other diagnostic products for critical health conditions such as sepsis. We also focused on the development of potential improvements to our existing products, including our Triage Cardiac Panel, manufacturing processes and research activities associated with Biosite Discovery. Expenses related to the performance of our obligations associated with earning our contract revenues were incurred by our R&D group and were primarily related to Biosite Discovery.
License and Patent Disputes. Expenses associated with license and patent disputes were $2.0 million in 2005, compared to $178,000 in 2004. The expenses consisted of legal costs related to our litigation with Roche Diagnostics Corporation and its affiliates.
Interest and Other Income, Net. Interest and other income, net was $2.7 million for 2005, compared to $1.3 million for 2004. The increases resulted primarily from an increase in interest income due to higher average balances of cash and marketable securities and higher interest rates in 2005 compared to 2004.
Provision for Income Taxes. As a result of the pre-tax income and the estimated tax credits and other permanent differences between our reported and tax results in 2005, we recorded a provision for income taxes of $32.3 million for 2005, equivalent to an effective tax rate of 37.4%. For 2004, we recorded a provision for income taxes of $24.2 million, equivalent to an effective tax rate of 36.8%. The increase in the effective tax rate was due primarily to a decrease in R&D tax credits generated in 2005 as compared to 2004. The 2005 R&D tax credits were limited by the statutory restriction that limits the tax credits to research expenses as a percentage of product sales.
Liquidity and Capital Resources
Historically, our sources of cash have included:
· cash generated from operations, primarily from the collection of accounts receivable resulting from product sales;
· private and public placements of equity securities, including cash generated from the exercise of stock options and participation in our ESPP;
· proceeds from equipment financing;
· cash received under collaborative development agreements; and
· interest income.
Our historical cash outflows have primarily been associated with:
· cash used for operating activities such as the purchase and growth of inventory, expansion of our sales and marketing and R&D activities and other working capital needs;
· the purchase of land and construction of facilities;
· cash used for our stock repurchase programs; and
· expenditures related to equipment and improvements used to increase our manufacturing capacity, improve our manufacturing efficiency and expand our research and development activities.
Other factors that impact our cash inflow and outflow include the following:
· We have experienced gross margins greater than 65% and operating margins greater than 19% in each of the last three years. As our product sales have increased significantly since 2001, our gross profit and operating income have increased significantly as well, providing us with an increased source of cash to finance the expansion of our operations; and
· Fisher, which accounted for 81% of our product sales in 2006, has historically been a timely and predictable payor of its outstanding accounts receivable. We have a distribution relationship with Fisher that expires on December 31, 2008; and
· fluctuations in our working capital.
As of December 31, 2006, we had cash, cash equivalents and marketable securities of $64.2 million compared with $132.4 million as of December 31, 2005. The primary inflow of cash during 2006 was approximately $75.1 million generated from operating activities, for which the sales volume growth of our cardiovascular products was the primary driver. Additionally, we generated $22.9 million in cash from proceeds from the issuance of shares under our stock plans during 2006. Future proceeds from exercise of stock options and participation in our employee stock purchase plan will depend primarily upon the behavior, expectations and needs of the plan participants and upon our stock price.
The primary cash outflow during 2006 was attributable to the repurchase of an aggregate of approximately 2.5 million shares of our common stock for approximately $130.0 million, including commissions. Another non-operating cash outflow during 2006 was $24.0 million used for the purchase of property and equipment, including $6.4 million for the purchase of a plastic injection molding facility in San Clemente, California.
In October 2006, our Board of Directors approved a $100.0 million stock repurchase program. In connection with this stock repurchase program, we entered into a privately negotiated transaction with Goldman, Sachs & Co. to repurchase $100.0 million of our common stock. The agreement includes collar provisions that establish the minimum and maximum numbers of shares to be repurchased. The specific number of shares to be repurchased is generally based on the volume-weighted average share price of our common shares during the six- to nine-month term of the accelerated repurchase agreement, subject to collar limits. In the fourth quarter of 2006, we paid Goldman Sachs $100.0 million in exchange for 1.9 million shares that were received and retired. This repurchase was made using our own cash reserves. Upon termination of the program in July 2007, we may be entitled to additional shares subject to the collar provisions. In addition, we repurchased an additional approximate 576,000 shares of our common stock for $30.0 million in the first quarter of 2006.
In October 2003, we completed our purchase of approximately 26.1 usable acres of land for the construction of our corporate complex. This land provides us with the potential for up to 800,000 square feet of space, to be constructed in phases as needed. The first phase, which is now complete, provides us with approximately 350,000 square feet of space. The total cost of the land and the construction of the first phase was approximately $110.0 million. We have relocated all of our operations to the new corporate complex. From time to time we will
continue to evaluate the need to commence the next phase of construction of our corporate complex. We also will continue to evaluate the purchase of additional land or improved facilities to meet our future business needs. We expect our future occupancy costs to increase primarily due to increased square footage for our operations.
In December 2006, we entered into an agreement to lease approximately 17.2 acres of land adjacent to our current San Diego corporate complex. The lease is effective February 1, 2007 and expires January 31, 2012, subject to certain early termination rights. Under this agreement, in consideration for an annual non-refundable option payment of $500,000, we also have an option to purchase this property at any time between September 1, 2007 and August 31, 2009. If we elect to exercise the purchase option, the purchase price for the property will be equal to 97% of its fair market value at the time that we exercise the option, but in any event not more than approximately $33.7 million and not less than approximately $26.1 million, and any option payments will be applied to the final purchase price for the property.
In September 2006, we completed our purchase of a facility in San Clemente, California for $6.4 million. The facility is approximately 38,000 square feet and will be utilized to manufacture plastic parts for our diagnostic test kits. We are currently making improvements to the facility and installing equipment needed for its operation. Pending the completion of those tasks and the recruitment and training of additional personnel, we expect manufacturing operations to commence at the San Clemente facility in the first half of 2007.
Should there be a downturn in our business or the markets in which we compete, we may not have a need to expand our facilities as we have planned. As a result, we may then seek an alternative use for all or a portion of some or all of our property, or seek to sell some or all of our property, which may have a negative impact on our operating results. We may also incur unexpected costs and expenses in connection with a move from existing facilities to new facilities, or we may experience unanticipated decreases in productivity and other losses due to inefficiencies relating to any such transition, or delays in obtaining any required approvals or clearances from regulatory agencies related to the validation of any new manufacturing facilities.
Our primary short-term needs for capital, which are subject to change, include expenditures related to:
· the potential repurchase of our common stock;
· clinical studies, and the continued advancement of research and development efforts;
· support of our commercialization efforts related to our current and future products, including expansion of our direct sales force and field support resources both in the United States and abroad;
· improvements in our manufacturing capacity and efficiency, new discovery and product development efforts;
· the acquisition of equipment and other fixed assets for use in our current and future facilities, and for manufacturing and research and development purposes;
· our facilities expansion needs, including potential costs of purchasing additional land or improved facilities; and
· potential up-front or milestone payments under licensing agreements that cover intellectual property rights of third parties.
For 2007, we plan to spend approximately $25.0 million in cash for capital expenditures, primarily for manufacturing and R&D equipment, furniture, fixtures and computer equipment and for facilities improvements. We intend to use our currently available cash and cash we expect to generate from operating activities to address our capital requirements. We expect that the performance of our product sales and the resulting operating income, as well as the status of each of our new product development programs, will significantly impact our cash management decisions. We have utilized, and may continue to utilize, credit arrangements with financial institutions to finance the purchase of capital equipment. Factors such as interest rates and available cash will impact our decision to continue to utilize credit arrangements as a source of cash.
We believe that our available cash, cash from operations and proceeds from the issuance of stock under our stock plans will be sufficient to satisfy our funding needs for at least the next 24 months, except in the event that we determine to accelerate the development and/or construction of the remaining phases of our corporate complex or purchase additional land or improved facilities. We used our available cash balances to purchase the land for our new corporate complex and pay for the design and construction costs. We also used available cash balances to repurchase $130.0 million of our common stock during 2006. During the fourth quarter of 2006, we used our available cash to make an $8.5 million payment to Roche under the terms of our settlement agreement. If cash generated from operations is insufficient to satisfy our working capital and capital expenditure requirements, we may be required to sell additional equity or debt securities or obtain additional credit facilities. Additional capital, if needed, may not be available on satisfactory terms, if at all. Furthermore, any additional equity financing may be
dilutive to stockholders, and debt financing, if available, may include restrictive covenants. Factors such as interest rates and available cash will impact our decision to continue to utilize credit arrangements as a source of cash. Our future liquidity and capital funding requirements will depend on numerous factors, including:
· the timing and amount of any additional repurchase of our stock;
· the scope, costs, timing and results of research and development efforts, including clinical studies and regulatory actions regarding our potential products;
· the extent to which our new products and products under development are successfully developed, gain regulatory approval and market acceptance and become and remain competitive;
· the costs, timing and effectiveness of further expansion of sales, marketing and manufacturing activities and resources;
· expansion of our manufacturing capacity and our facilities expansion needs, including the possible purchase of land adjacent to our San Diego corporate complex;
· the effects of competition, including products competitive with our Triage BNP Tests, from companies with greater financial capital and resources;
· the effect on sales and cash receipts for our Triage BNP Tests due to market saturation in the hospital market for natriuretic peptide testing in the United States;
· regulatory changes, uncertainties or delays;
· the impact of the prosecution, defense and resolution of potential future license and patent disputes;
· seasonal or unanticipated changes in customer demand;
· the timing and amount of any early retirement of our debt;
· changes in third-party reimbursement policies;
· the ability to execute, enforce and maintain license and collaborative agreements and attain the milestones under these agreements necessary to earn contract revenues; and
· the costs and timing associated with business development activities, including potential licensing of technologies patented by others.
Our failure to raise capital on acceptable terms, when needed, could have a material adverse effect on our business.
Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2006. This table should be read in conjunction with the remainder of this Item 7, ”Management’s Discussion and Analysis of Financial Condition and Results of Operations”, as well as in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K.
(1) Operating lease obligations includes the annual option payments of $500,000 for 2007, 2008 and 2009 related to the option to purchase approximately 17.2 acres of land adjacent to our current San Diego corporate complex.
(2) Purchase obligations include commitments to purchase components and raw materials used in the manufacture of our products, and other recurring purchases and services, including clinical trial services, made in the normal course of business to meet operational and capital expenditure requirements.
We have executed agreements to license technologies that are covered by the intellectual property rights of third parties. The financial and commercial terms of each of these agreements vary significantly, and in virtually all cases our payment obligations under any individual agreement are not material to our business as a whole. For the most part, the license agreements call for potential cash outflows for milestone payments and future royalties based on product sales utilizing the licensed technologies. The milestone payments under these agreements are primarily dependent on achieving product development goals, commencement of clinical studies of a product utilizing the
licensed technology or meeting commercialization objectives, or any combination thereof. Examples of milestones for which we would make payments would include: 1) initiation of clinical studies of a potential product that is covered by the licensed technologies, 2) FDA clearance to market a product that is covered by the licensed technologies, and 3) the first sale of a product that is covered by the licensed technologies in a specific territory. The attainment of the milestones is highly uncertain and dependent upon many contingencies. Additionally, we exercise discretion whether to continue to utilize the licensed technologies. At any time, we may, for technical or economic reasons, decide to discontinue utilizing the licensed technologies and would incur no further financial obligations beyond those payments already made. As of December 31, 2006, there were no milestones, either individually or in the aggregate, under our licensing and collaborative agreements for which we believe material payments were required to be made, and, in the future, we believe that there are approximately $1.3 million in payments that are reasonably likely to be made.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk We are exposed to changes in interest rates, primarily from our investments in available-for-sale marketable securities. Under our current policies, we do not use interest rate derivatives instruments to manage this exposure to interest rate changes. A hypothetical 1% adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our financial instruments that are exposed to changes in interest rates.
Since 2003, we have significantly expanded our direct sales and distribution operations in Switzerland, France, Germany, Belgium, Luxembourg, the United Kingdom, Italy and the Netherlands, and we may expand into additional countries in the future. Sales and costs resulting from these direct sales operations are denominated in local currencies and are subject to fluctuations in currency exchange rates from the translation of these operations to U.S. dollars. Further, we routinely enter into transactions in currencies other than the U.S. dollar, such as purchases of our Triage Meter inventory from LRE Technology Partner Gmbh, or LRE, intercompany sales of inventory to our foreign subsidiaries, leases of facilities outside the United States and other operating costs. As a result, our costs will fluctuate along with the currencies and general economic conditions in the countries in which we do business, which could negatively impact our financial results.
We have on occasion purchased forward exchange contracts to manage specific currency exposures to exchange rate changes and may do so in the future. As of December 31, 2006, we had outstanding forward exchange contracts with a notional principal value of $2.1 million, settling on various dates through May 2007. Including the impact of net gains and losses on these forward exchange contracts, we recognized a net currency exchange gain on foreign currency denominated transactions of $257,000 for 2006, compared to a net loss of $207,000 for 2005. The effect of an immediate 10% change in foreign exchange rates would not have a material impact on our financial condition or results of operations.
International sales and operations are also subject to a variety of other risks, including:
· slower payment practices than those in the United States, increasing the risk of uncollectible accounts;
· difficulty in staffing, monitoring and managing foreign operations;
· understanding of and compliance with local employment laws, including reduced flexibility and increased cost of staffing adjustments;
· unknown or changes in regulatory practices, including import or export license requirements, trade barriers, tariffs, employment and tax laws;
· adverse tax consequences, including imposition of withholding or other taxes on payments by subsidiaries;
· restrictions on repatriation of locally-derived revenue;
· competition from locally-produced products with cost advantages or national appeal;
· local business practices that could expose our direct sales and marketing organization to Foreign Corrupt Practices Act risks;
· political, social or economic conditions and changes in these foreign markets; and
· government spending patterns.
Item 8.
Item 8. Financial Statements and Supplementary Data Refer to the Index on Page F-l hereto.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable.
Item 9A.
Item 9A. Controls and Procedures Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, or the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Annual Report on Form 10-K.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2006 based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
The Board of Directors and Stockholders
Biosite Incorporated
We have audited management’s assessment, included in the accompanying Management’s Assessment of Internal Controls Over Financial Reporting, that Biosite Incorporated maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Biosite Incorporated’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Biosite Incorporated maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Biosite Incorporated maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Biosite Incorporated as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 of Biosite Incorporated and our report dated February 23, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
San Diego, California
February 23, 2007
Item 9B.
Item 9B. Other Information Not applicable.
PART III
Some information required by Part III is incorporated by reference from our definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for our 2007 Annual Meeting of Stockholders (the “Proxy Statement”).
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance. The information required by this item is contained in the sections entitled “Election of Directors”, “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation The information required by this item is contained in the section entitled “Executive Compensation” in the Proxy Statement and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this item is contained in the sections entitled “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” and “Equity Compensation Plan Information” in the Proxy Statement and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this item is contained in the sections entitled “Certain Relationships and Related Transactions” and “Election of Directors” in the Proxy Statement and it incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services The information required by this item is contained in the section entitled “Ratification of Selection of Independent Auditors” in the Proxy Statement and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules (a) (1) Financial Statements
Refer to the Index on page F-l hereto.
(2) Financial Statement Schedules
Refer to Schedule II, Valuation and Qualifying Accounts, hereto.
The other financial statement schedules required by this item have been omitted since they are either not required, not applicable or the information is otherwise included herein.
(3) Exhibits
EXHIBIT
NUMBER
DESCRIPTION OF DOCUMENT
3.1(1)
Restated Certificate of Incorporation.
3.2(1)
Certificate of Amendment to the Restated Certificate of Incorporation.
3.3(1)
Certificate of Designation, Rights and Preferences of Series A Participating Preferred Stock.
3.4(2)
Certificate of Amendment to the Restated Certificate of Incorporation.
3.5(3)
Certificate of Amendment to the Restated Certificate of Incorporation.
3.6(4)
Amended and Restated Bylaws.
4.1(2)
Form of Common Stock Certificate with rights legend.
10.1(5) (A)
Amended and Restated 1989 Stock Plan of Biosite Incorporated.
10.2(6) (A)
Amended and Restated 1996 Stock Incentive Plan of Biosite Incorporated (“1996 Stock Plan”).
10.3 (A)
Form of Incentive Stock Option Agreement under the 1996 Stock Plan.
10.4 (A)
Form of Nonstatutory Stock Option Agreement under the 1996 Stock Plan.
10.5 (7)(A)
Biosite Incorporated 2002 Nonqualified Stock Incentive Plan.
10.6 (A)
Form of Nonstatutory Stock Option Agreement under the 2002 Stock Plan.
10.7(8) (A)
Biosite Incorporated Amended and Restated Employee Stock Purchase Plan.
10.8(9) (A)
Biosite Incorporated Executive Bonus Plan.
10.9(10) (A)
Biosite Incorporated Change in Control Severance Benefit Plan.
10.10(10) (A)
Form of Director Fee Deferral Program under the 1996 Stock Plan.
10.11(11) (A)
Biosite Incorporated Nonqualified Deferred Compensation Plan effective June 1, 2002.
10.12(12) (A)
Biosite Incorporated 409A Nonqualified Deferred Compensation Plan effective January 1, 2005.
10.13(13) (A)
Form of Indemnity Agreement between the Biosite and its officers and directors.
10.14(5)
Development, Supply and Distribution Agreement between Biosite and Kyoto Dai-Ichi Kagaku Co., Ltd., dated as of February 14, 1995.
10.15(14)
Rights Agreement dated as of October 22, 1997 between Biosite (formerly Biosite Diagnostics Incorporated) and Fleet National Bank (f/k/a BankBoston, N.A.) as Rights Agent.
10.16(15)
Amendment No. 1 to Rights Agreement dated as of December 9, 1999 between Biosite Incorporated (formerly Biosite Diagnostics Incorporated) and Fleet National Bank (f/k/a BankBoston, N.A.) as Rights Agent.
10.17(16)
Amendment No. 2 to Rights Agreement dated as of July 18, 2001 between Biosite Incorporated (formally Biosite Diagnostics Incorporated) and Fleet National Bank (f/k/a BankBoston, N.A.) and American Stock Transfer and Trust as successor Rights Agent.
10.18(17)(*)
Distribution Agreement between Biosite and Fisher Scientific Company L.L.C. effective January 1, 2006.
10.19(17)(*)
Semi-exclusive BNP Diagnostic License Agreement between Biosite Diagnostics Incorporated and Scios, Inc. effective December 30, 1996.
10.20(17) (*)
First Amendment to Semi-exclusive BNP Diagnostic License Agreement between Biosite Diagnostics Incorporated and Scios, Inc. effective August 1, 1997.
10.21(17) (*)
Amendment #2 to Semi-exclusive BNP Diagnostic License Agreement between Biosite Incorporated and Scios, Inc. effective August 30, 2002.
10.22(17) (*)
BNP Assay Development, Manufacture and Supply Agreement between Biosite Incorporated and Beckman Coulter, Inc. effective June 24, 2003.
10.23(18)
Patent License and Settlement Agreement dated as of July 25, 2006 among Biosite Incorporated, Roche Diagnostics Corporation, Roche Diagnostics Operations, Inc., Roche Diagnostics GmbH and Corange International, Ltd.
10.24(19) (A)
Transition Agreement effective January 25, 2006 between Biosite Incorporated and Thomas M. Watlington.
21.1
Subsidiaries of the Company.
23.1
Consent of Independent Registered Public Accounting Firm.
31.1
Section 302 Certification of Kim D. Blickenstaff, Chief Executive Officer
31.2
Section 302 Certification of Christopher J. Twomey, Chief Financial Officer
32.1
Section 906 Certification of Kim D. Blickenstaff, Chief Executive Officer
32.2
Section 906 Certification of Christopher J. Twomey, Chief Financial Officer
(1) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001.
(2) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003.
(3) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005.
(4) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003.
(5) Incorporated by reference to an exhibit to Biosite’s Registration Statement on Form S-1, No. 333-17657.
(6) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.
(7) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005.
(8) Incorporated by reference to Exhibit B to Biosite’s Definitive Proxy Statement dated April 27, 2004 and filed with the Securities and Exchange Commission.
(9) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003.
(10) Incorporated by reference to an exhibit to Biosite’s Annual Report on Form 10-K for the year ended December 31, 2004.
(11) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003.
(12) Incorporated by reference to an exhibit to Biosite’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005.
(13) Incorporated by reference to Exhibit B to Biosite’s Definitive Proxy Statement dated April 27, 2004 and filed with the Securities and Exchange Commission.
(14) Incorporated by reference to Exhibit 4.1 to Biosite’s Registration Statement on Form 8-A, filed on October 28, 1997.
(15) Incorporated by reference to Exhibit 4.2 to Amendment No. 1 to Biosite’s Registration Statement on Form 8-A, filed on July 18, 2001.
(16) Incorporated by reference to Exhibit 4.3 to Amendment No. 1 to Biosite’s Registration Statement on Form 8-A, filed on July 18, 2001.
(17) Incorporated by reference to an exhibit to Biosite’s Annual Report on Form 10-K for the year ended December 31, 2005.
(18) Incorporated by reference to an exhibit to Biosite’s Current Report on Form 8-K, filed on July 26, 2006.
(19) Incorporated by reference to an exhibit to Biosite’s Current Report on Form 8-K, filed on March 6, 2006.
(A) Indicates management contract or compensatory plan or arrangement.
(*) Confidential treatment has been requested for certain portions of these exhibits, which have been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934.
b) Exhibits
Refer to Item 15(a)(3) above.
c) Financial Statement Schedules
Refer to Item 15(a)(2) above.
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
BIOSITE INCORPORATED
/s/ KIM D. BLICKENSTAFF
Date: February 22, 2007
Kim D. Blickenstaff
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name
Title
Date
/s/ KIM D. BLICKENSTAFF
Chairman of the Board and
February 22, 2007
Kim D. Blickenstaff
Chief Executive Officer (Principal
Executive Officer)
/s/ CHRISTOPHER J. TWOMEY
Senior Vice President, Finance, Chief Financial
February 22, 2007
Christopher J. Twomey
Officer and Secretary
(Principal Financial Officer and Accounting
Officer)
/s/ TIMOTHY J. WOLLAEGER
Director
February 22, 2007
Timothy J. Wollaeger
/S/ KENNETH F. BUECHLER, PH.D.
Director, President and Chief Scientific Officer
February 22, 2007
Kenneth F. Buechler, Ph.D.
/s/ ANTHONY DEMARIA, M.D.
Director
February 22, 2007
Anthony DeMaria, M.D.
/s/ HOWARD E. GREENE, JR.
Director
February 22, 2007
Howard E. Greene, Jr.
/s/ LONNIE M. SMITH
Director
February 22, 2007
Lonnie M. Smith
Biosite Incorporated
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2006 and 2005
Consolidated Statements of Income for each of the three years in the period ended December 31, 2006
Consolidated Statements of Stockholders’ Equity for each of the three years in the period ended December 31, 2006
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2006
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Biosite Incorporated
We have audited the accompanying consolidated balance sheets of Biosite Incorporated as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Biosite Incorporated at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, effective January 1, 2006 Biosite Incorporated changed its method of accounting for share-based payments as required by Statement of Financial Accounting Standards No. 123 (revised 2004).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Biosite Incorporated’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
San Diego, California
February 23, 2007
BIOSITE INCORPORATED
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)
See accompanying notes.
BIOSITE INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
See accompanying notes.
BIOSITE INCORPORATED
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
See accompanying notes.
BIOSITE INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes.
BIOSITE INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. Organization and Summary of Significant Policies
Organization and Business Activity. Founded in 1988, Biosite® Incorporated is a global medical diagnostic company utilizing a biotechnology approach to create products for the diagnosis of critical medical diseases and conditions. We operate in one business segment - immunoassay diagnostics. Our business goal is to compile a portfolio of high-value products by leveraging our research and development advances to provide customers with new diagnostic offerings intended to improve upon existing methods and products. To do this, we focus on patenting novel protein biomarker panels, manufacturing complex products at appreciable profit margins, employing strategic clinical studies and trials to validate our products’ diagnostic utilities, and educating healthcare providers on the benefits of our diagnostic tests.
We market diagnostic products in the areas of cardiovascular disease, drug screening and infectious diseases. Today our principal products are the Triage BNP Tests, which measure B-type natriuretic peptide, a hormone present at elevated levels in patients with heart failure, and the Triage Profiler product line, which includes multiple marker panels intended to aid in diagnosis of various cardiovascular conditions. In 2006, sales of the Triage BNP Tests and the Triage Profiler products represented 71% of product sales.
The Fisher HealthCare Division of the Fisher Scientific Company, or Fisher, distributes our products primarily in hospitals in the United States and supports our direct sales force, particularly in smaller hospitals. In November 2006, Fisher completed a merger with Thermo Electron Corporation. We utilize distributor relationships with Physician Sales & Services, or PSS, and Henry Schein, Inc., or Henry Schein, to market our products to physician office laboratories in the United States. In international markets, we have established direct selling efforts in several European countries and utilize a network of country-specific and regional distributors in other areas. Since 2003, we have initiated direct sales and distribution operations in France, Germany, Belgium and Luxembourg, the United Kingdom, Italy, the Netherlands and Switzerland. In the future, we may transition to direct sales and distribution of our products in additional countries.
Principles of Consolidation. The consolidated financial statements include our financial statements and those of our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Revenue Recognition. We recognize product sales upon shipment, including to Fisher and our other distributors, unless there are significant post-delivery obligations or collection is not considered probable at the time of shipment. Generally, we do not have any significant post-delivery obligations associated with our product sales and our credit losses have been minimal. We record an estimate of end-user sales rebates as a reduction of product sales at the time of shipment. The sales rebates are primarily earned by the customer under a contract, payable by us at a specified rate and are based on an estimate of the customer’s attainment of a specified minimum purchase level for a specified product over a stated period of time. We do monitor inventory levels of our products at Fisher and historically, those levels have been, on average, approximately one month or less.
Our collaborative development agreements generally contain specific payments for specific activities or elements of the agreements. Among the payments we might receive under the agreements are: up-front technology access fees, research funding, antibody development fees upon the delivery of antibodies, annual maintenance fees on targets for which we have produced antibodies for as long as the targets remain in development by our collaborators, milestone fees on drug targets that reach certain development milestones and royalties should products successfully be commercialized as a result of the collaboration. Up-front technology access fees are recognized over the term of the agreement or ongoing research period, as applicable, unless we have no further continuing performance obligations related to the fees. Research funding is recognized over the applicable research period on a straight-line basis, which approximates the underlying performance. Milestone payments, such as antibody development fees and clinical milestones, are recognized when earned, as the milestone events are substantive and their achievability is not reasonably assured at the inception of the agreement. Contract revenues that are based on the performance of and collection by our collaborators or their partners are deferred until such performance is complete and collection is probable. We believe that each payment element of these agreements represents the fair value of the element at the date of the agreement.
Segment Information, Major Customers and Suppliers. Financial Accounting Standards Board, or FASB, Statement No. 131, Segment Information, FAS 131, amends the requirements for public enterprises to report financial and descriptive information about their reportable operating segments. Operating segments, as defined in
FAS 131, are components of an enterprise for which separate financial information is available and is evaluated regularly by us in deciding how to allocate resources and in assessing performance. FAS 131 also requires disclosures about our products and services, geographic areas and major customers.
Our management has determined that we currently operate principally in one operating segment: the discovery, development, manufacture and marketing of rapid, accurate and cost-effective diagnostics that improve the quality of patient care and simplify the practice of laboratory medicine. Our chief operating decision-making group is the Management Group, which is comprised of the Chief Executive Officer, President, Senior Vice Presidents and Vice Presidents. The Management Group primarily decides how to allocate resources based on the overall operating results and the contribution of each functional area towards achieving our business and financial goals. Our principal functional areas are: 1) Finance and Administration, 2) Sales and Marketing, 3) Research and Development and 4) Manufacturing.
We have a distribution agreement with Fisher that extends through December 31, 2008. Sales to Fisher represented 81%, 84% and 86% of our product sales in 2006, 2005 and 2004, respectively. At December 31, 2006 and 2005, receivable amounts due from Fisher represented approximately 57% and 64%, respectively, of our accounts receivable. Sales to international customers amounted to $44.6 million, $35.9 million and $26.0 million in 2006, 2005 and 2004, respectively.
Certain components and raw materials used in the manufacture of our products are provided by single-source vendors. Any supply interruption in a sole-sourced component or raw material would affect our ability to manufacture these products until a new source of supply is qualified or alternative manufacturing processes are implemented or developed. We generally maintain safety stock inventory levels of these items, which would allow us some additional time should we need to identify and qualify alternative suppliers. LRE Technology Partner GmbH, or LRE, is the sole manufacturer of the fluorescent meters used with our Triage Meter platform products, including the Triage BNP Test, Triage Cardiac Panel, Triage CardioProfiler, Triage Profiler Shortness of Breath Panel, Triage D-Dimer Test and Triage TOX Drug Screen and others currently under development, including the Triage Stroke Panel. Beckman Coulter, Inc. is the sole manufacturer of Biosite’s Triage BNP test for Beckman Coulter Immunoassay Systems, and related calibrations and controls for that product. Other sole-source suppliers provide selected components of our products.
Use of Estimates. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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.
Cash and Cash Equivalents. Cash and cash equivalents consist of cash and highly liquid investments in debt securities with maturities of 90 days or less when purchased.
Marketable Securities. Based on the nature of the assets held by us and management’s investment strategy, our investments have been classified as either available-for-sale or trading securities. Management determines the appropriate classification of securities at the time of purchase. Securities classified as available-for-sale or trading are carried at estimated fair value, as determined by quoted market prices at the balance sheet date. The net unrealized gains or losses on available-for-sale securities, net of tax, are reported as a component of comprehensive income. Unrealized gains or losses on trading securities are reported in interest income. At December 31, 2006, we had no investments that were classified as held-to-maturity. The amortized cost of debt securities classified as available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses on sales of available-for-sale securities are computed based upon the amortized cost adjusted for any other than temporary declines in fair value and are included in interest income. The cost of securities sold is based on the specific identification method. Interest on trading securities and securities classified as available-for-sale is included in interest income.
Forward Contracts. The Company may use derivative financial instruments to offset foreign currency exchange rate exposures on certain transactions denominated in currencies other than the U.S. dollar. All derivatives are recorded on the balance sheet at fair value. As of December 31, 2006, we had outstanding forward exchange contracts with a notional principal value of $2.1 million, settling on various dates through May 2007. The outstanding contracts were not designated as hedges and, therefore, the changes in fair value of these contracts were recognized immediately in earnings.
Accounts Receivable. Accounts receivable consists of trade receivables due from customers for the sale of our products. Payment terms vary on a customer by customer basis, and generally range from cash on delivery to net, 60 days in the United States and from cash in advance to net, 120 days internationally. We also utilize various programs, including letters of credit and insurance, to reduce risks of uncollectibility. A receivable is considered past due when it has exceeded its payment terms. Accounts receivable has been reduced by an estimated allowance for doubtful accounts. We estimate our allowance for doubtful accounts based on facts, circumstances and judgments regarding each account. Our estimate is determined by analysis of items such as historical bad debts, customer payment history and patterns, customer creditworthiness, economic, political or regulatory factors affecting the customer’s ability to make the required payments and individual circumstances.
Inventories and Related Allowances. Net inventories are valued at the lower of the first-in, first-out, or FIFO, cost or market value and have been reduced by an allowance for excess, obsolete and potential scrap inventories. The estimated allowance for excess, obsolete and potential scrap inventories is based on inventories on hand compared to estimated future usage and sales, and assumptions about the likelihood of scrap or obsolescence. During our manufacturing processes, some work-in-process inventories require additional testing or re-work to meet technical specifications. These inventories are tracked using a specific identification method and reviewed on a monthly basis to determine their status and an estimated reserve for potential scrap is calculated. Our estimates for potential scrap for these inventories may change as further testing and re-work is performed. If actual scrap is different from our estimates, revisions to the scrap reserve would be required at the time of such determination and could positively or negatively affect our reported operating results.
We regularly review inventory quantities on hand and record an allowance for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements for the next two to five years. Future events or factors may affect the net realizable value of our inventories and our estimates and assumptions used to determine our allowance for excess, obsolete and potential scrap inventories. Such events or factors include manufacturing quality, unanticipated acceleration or deceleration of product demand, changes in technology or production methods and new product development. These factors could result in an increase or decrease of our estimates of excess, obsolete or potential scrap inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the allowance required for excess, obsolete and potential scrap inventory. In the future, if we determine that the estimated net realizable value of our inventory may be overstated, we will record such reduction in value as additional cost of sales at the time of such determination. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated change in demand or technological development could have a significant impact on the value of our inventory and our reported operating results.
We utilize a standard cost system to track our inventories on a part-by-part basis. When necessary, adjustments are made to the standard materials, standard labor and standard overhead costs to approximate actual labor and actual overhead costs on a FIFO cost basis.
Warranty Reserve. Our warranty reserve primarily relates to warranty coverage that we offer with the placement of the Triage Meter. The Triage Meter is manufactured by LRE who provides Biosite a contractual warranty against manufacturer’s defects and poor workmanship. Should a meter not function to specification and the cause is determined to be due to a manufacturer’s defect or poor workmanship, the malfunctioning meter would be returned to LRE for replacement or repair. LRE would incur and bear all the cost to replace or repair the meter. We have established a warranty allowance for the costs to replace or repair meters that would not be covered by LRE’s warranty. Historical experience and trends detailing returns and replacement activity in total and those that have been covered by LRE’s manufacturer’s warranty are used in estimating our warranty allowance.
Property and Equipment, Net. Property and equipment are stated at historical cost, net of accumulated depreciation.
Depreciation and Amortization. Depreciation of equipment is computed using the straight-line method over the estimated useful lives of the assets, generally three to seven years. Building and building improvements are depreciated over their estimated useful lives ranging from five to forty years. Useful lives are based on management’s estimates of the period that the assets will generate revenue directly or indirectly.
License Rights. License rights related to products for sale are stated at cost and amortized to cost of sales over the life of the license, not to exceed ten years, using a systematic method based on the estimated revenues generated from products during generally the shorter of the license period or ten years from the inception of the license. The
estimated revenues used as the base by which we amortize the license rights include only estimated sales for products we are currently selling and do not include any estimated product sales expected to be realized during the license amortization term from products still in development today.
Long-lived and Intangible Assets. Our policy is to review the carrying amounts of long-lived and intangible assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Such events or circumstances might include a significant decline in market share, a significant decline in profits, rapid changes in technology, significant litigation or other items. In evaluating the recoverability of intangible assets, management’s policy is to compare the carrying amounts of such assets with the estimated undiscounted future operating cash flows. In the event impairment exists, an impairment charge would be determined by comparing the carrying amount of the asset to the applicable estimated future cash flows, discounted at a risk-adjusted interest rate. In addition, the remaining amortization period for the impaired asset would be reassessed and revised if necessary. We do not believe the carrying amounts of long-lived and intangible assets are impaired at December 31, 2006.
Stock-Based Compensation. In December 2004, the FASB issued a revised Statement of Financial Accounting Standards No. 123, or FAS 123(R), Share-Based Payment. Under FAS 123(R), the estimated fair value of share-based payments is measured at the grant date and is recognized as stock-based compensation expense over the employee’s requisite service period. We adopted the provisions of FAS 123(R) on January 1, 2006 using the modified prospective method, which provides for certain changes to the method for valuing stock-based compensation. Under the modified prospective method, prior periods are not revised for comparative purposes. The valuation provisions of FAS 123(R) apply both to new stock-based awards issued beginning January 1, 2006 and to awards that were already outstanding on January 1, 2006 but are subsequently modified or cancelled. The estimated fair value of new stock-based awards is recognized as stock-based compensation over the requisite service period associated with the award. For awards already outstanding at January 1, 2006, the estimated stock-based compensation is recognized over the remaining service period using the compensation cost calculated for pro forma purposes under FASB Statement No. 123, Accounting for Stock-Based Compensation, or FAS 123.
As a result of the adoption of FAS 123(R), we recorded $24.9 million of stock-based compensation expense in the year ended December 31, 2006. We also recorded a $7.2 million income tax benefit related to stock-based compensation for 2006. Beginning in the first quarter of 2006, we have recognized tax benefits resulting from the exercise of stock-based compensation awards in excess of the tax benefit calculated at the grant date based on the fair value of the award as a cash inflow from financing activities instead of a reduction of cash outflow for income taxes under cash provided by operating activities in the Consolidated Statements of Cash Flows. For 2006, this also includes the tax benefit on options vested prior to the adoption of FAS 123(R). In addition, as also required by FAS 123(R), we capitalized approximately $758,000 of stock-based compensation as part of the cost of our inventory at December 31, 2006.
FAS 123(R) requires the use of a valuation model to calculate the fair value of each stock-based award. Since April 1, 2005, we have used the Aon Actuarial Binomial Model, which was provided by Aon Consulting, to estimate the fair value of stock options granted. For our Employee Stock Purchase Plan, or ESPP, we estimate the fair value of stock purchase rights granted using the Black-Scholes option valuation model. For all stock options and stock purchase rights granted prior to April 1, 2005, the fair value for proforma purposes was determined using the Black-Scholes model. We believe that the binomial model considers characteristics of fair value option pricing that are not available under the Black-Scholes model. Similar to the Black-Scholes model, the binomial model takes into account variables such as expected volatility, expected dividend yield rate and risk free interest rate. However, in addition, the binomial model considers the contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life, and the probability of termination or retirement of the option holder in computing the value of the option.
Stock-Based Compensation Information under FAS 123(R)
For the valuation of stock-based awards granted in 2006, we used the following significant assumptions:
Compensation Amortization Period. All stock-based compensation is amortized over the requisite service period of the awards, which is generally the same as the vesting period of the awards. For all stock options, we amortize the fair value on a straight-line basis over the service periods.
Expected Term or Life. The expected term or life of stock options granted or stock purchase rights issued represents the expected weighted average period of time from the date of grant to the estimated date that the stock option or stock purchase right under our ESPP would be fully exercised. To calculate the expected term, we use the historical stock options and stock purchase rights exercise behavior of our employees, and for unexercised options, we assume that unexercised stock options would be exercised at the midpoint between the current date of our analysis and the end of the contractual term of the option.
Expected Volatility. Expected volatility is a measure of the amount by which our stock price is expected to fluctuate. We estimate the expected volatility of our stock options at their grant date, placing equal weighting on the historical volatility and the implied volatility of our stock. The historical volatility was calculated using the daily stock price of our stock over a recent historical period equal to our expected term. The implied volatility is calculated from the implied market volatility of exchange-traded call options on our common stock. For the valuation of stock purchase rights, we exclusively rely on the implied volatility in estimating the expected volatility of our stock purchase rights since the expected term of our stock purchase rights is more consistent with the contractual terms of the exchange-traded call options.
Risk-Free Interest Rate. The risk-free interest rate that we use in determining the fair value of our stock-based awards is based on the implied yield on U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term of our stock-based awards.
Expected Dividends. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in our valuation models.
Expected Forfeitures. As stock-based compensation expense recognized in the Consolidated Statements of Income for 2006 is based on awards that are ultimately expected to vest, it is reduced for estimated forfeitures. FAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated to be 5% for stock options granted for 2006 based upon historical forfeitures.
Summary of Significant Assumptions of the Valuation of Stock-Based Awards. The weighted-average estimated fair value of stock options granted during 2006 was $21.55 per share. The weighted-average estimated fair value of stock purchase rights granted during 2006 was $16.00 per share. The fair value for these stock options and stock purchase rights was estimated at the date of grant with the following weighted-average assumptions for 2006:
The assumptions related to expected volatility and risk-free interest rate used for the valuation of stock options under our stock plans differ from those used for the valuation of our stock purchase rights under our ESPP primarily due to the difference in their respective expected lives.
Effect of Stock-Based Compensation on our Condensed Consolidated Statements of Income and Statements of Cash Flows. As a result of adopting FAS 123(R) for 2006, our pre-tax income and net income were lower by $24.9 million and $17.6 million, respectively, and our basic and diluted earnings per share were lower by $1.02 and $1.01, respectively, than if we had continued to account for stock-based compensation under Accounting Principles Board Opinion No. 25.
The total estimated stock-based compensation expense related to all of our stock-based awards recognized during 2006 was comprised as follows:
(in thousands, except per share data)
The total stock-based compensation capitalized as part of the cost of our inventory at December 31, 2006 was approximately $758,000.
As of December 31, 2006, there was $32.6 million of unrecognized stock-based compensation cost related to stock options which is expected to be recognized over a weighted-average period of 2.5 years and there was $2.1 million of unrecognized stock-based compensation cost related to ESPP stock purchase rights which is expected to be recognized over a weighted-average period of 8.1 months.
The adoption of FAS 123(R) resulted in a change in the presentation within our Statements of Cash Flows of excess tax benefits from stock-based awards exercised during 2006, resulting in a reduction in net cash provided by operating activities of $5.2 million and an equivalent increase in net cash provided by financing activities.
Pro Forma Information under FAS 123 for Periods Prior to 2006
Prior to adopting the provisions of FAS 123(R), we recorded estimated compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to APB Opinion No. 25, Accounting for Stock Issued to Employees and provided the required pro forma disclosures of FAS 123. As permitted by FAS 123, through December 31, 2005 we accounted for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, we recognized no compensation cost for employee stock options.
The weighted-average estimated fair value of stock options granted during 2005 and 2004 was $27.29 and $31.17 per share, respectively. The weighted-average estimated fair value of ESPP stock purchase rights granted during 2005 and 2004 was $24.76 and $16.23 per share, respectively. The fair value for these stock options and stock purchase rights was estimated at the date of grant with the following weighted-average assumptions for 2005 and 2004:
The following table illustrates the effect on our net income and net income per share for 2005 and 2004 as if we had applied the fair value recognition provisions of FAS 123 using the Black-Scholes valuation model (in thousands, except per share data):
Research and Development. Research and development costs are expensed as incurred. Such costs include personnel costs, supplies, clinical trials, technology access fees, consultants and services, allocated facilities, information systems, depreciation, amortization and other indirect costs.
Concentration of Credit Risk. We sell our products in the United States primarily to Fisher. Credit is extended based on an evaluation of the customer’s financial condition, and generally collateral is not required. We perform credit evaluations and maintain an allowance for potential credit losses. Credit losses in the United States have been minimal and within management’s expectations. In international markets, we have established direct selling efforts in several countries and utilize a network of country-specific and regional distributors in other areas. Beginning in 2003, we have significantly expanded our direct sales and distribution operations outside of the United States in France, Germany, Belgium and Luxembourg, the United Kingdom, Italy, the Netherlands and Switzerland, and we may expand into additional countries in the future. We also utilize various risk management programs, including letters of credit and insurance, to reduce risks of uncollectibility.
We invest our excess cash in debt instruments of the U.S. Government, state municipalities, financial institutions and corporations with strong credit ratings. We have established guidelines relative to diversification and maturities that maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.
Earnings Per Share. Basic earnings per share includes no dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities that could share in our earnings, such as common stock equivalents which may be issuable upon exercise of outstanding common stock options.
Shares used in calculating basic and diluted earnings per share were as follows (in thousands):
Comprehensive Income. FASB No. 130, Comprehensive Income, or FAS 130, establishes rules for the reporting and display of comprehensive income and its components. FAS 130 requires the change in net unrealized gains or losses on marketable securities and foreign currency translation adjustments to be included in comprehensive income. Comprehensive income is included in our Consolidated Statements of Stockholders’ Equity. The accumulated unrealized loss on marketable securities, net of tax, was $(37,000) and $(218,000) as of December 31, 2006 and 2005, respectively. The accumulated foreign currency translation gain or (loss) as of December 31, 2006 and 2005 was $457,000 and $(353,000), respectively.
Recent Accounting Pronouncements. In June 2006, the FASB issued Interpretation No. 48, or FIN 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FAS 109. FIN 48 provides clarification for the financial statement measurement and recognition of tax positions that are taken or expected to be taken in a tax return. FIN 48 is effective in the first quarter of 2007. We are currently evaluating the impact of FIN 48 on our financial statements.
NOTE 2. Licensing Rights and Agreements
We have executed agreements to license technologies that are covered by the intellectual property rights of third parties. The financial and commercial terms of each of these agreements vary significantly, and in virtually all cases our payment obligations under any individual agreement are not material to our business as a whole. For the most part, the license agreements call for potential cash outflows for milestone payments and future royalties based on product sales utilizing the licensed technologies. The milestone payments under these agreements are primarily dependent on achieving product development goals, commencement of clinical studies of a product utilizing the licensed technology or meeting commercialization objectives, or any combination thereof. Examples of milestones for which we would make payments would include: 1) initiation of clinical studies of a potential product that is covered by the licensed technologies, 2) FDA clearance to market a product that is covered by the licensed technologies, and 3) the first sale of a product that is covered by the licensed technologies in a specific territory. The attainment of the milestones is highly uncertain and dependent upon many contingencies. Additionally, we exercise discretion whether to continue to utilize the licensed technologies. At any time, we may, for technical or economic reasons, decide to discontinue utilizing the licensed technologies and would incur no further financial obligations beyond those payments already made. As of December 31, 2006, there were no milestones unaccounted for, either individually or in the aggregate, under our licensing and collaborative agreements for which we believe material payments are currently required to be made in the future. At December 31, 2006 and 2005, the total cost of license rights was $21.4 million and $12.3 million, respectively and accumulated amortization of the license rights was approximately $12.0 million and $7.5 million, respectively. Amortization expense of license rights totaled $4.7 million, $1.2 million and $1.2 million for the years ended December 31, 2006, 2005 and 2004, respectively. The estimated aggregate amortization expense related to license rights for the next five years and thereafter is as follows: 2007 - $2.1 million, 2008 - $1.8 million, 2009 - $1.1 million, 2010 - $1.1 million, 2011 - $1.1 million, thereafter - $2.2 million.
In July 2006, we entered into an agreement to settle a patent dispute with Roche Diagnostics Corporation. The settlement involves a worldwide, royalty-free, non-exclusive cross-license of certain patents involved in the two
cases. Under the terms of the settlement agreement, both parties dismissed our respective complaints in the lawsuits. We made a one-time license payment of $8.5 million to Roche. Of the $8.5 million license payment, $2.9 million was recognized in the second quarter of 2006 as license amortization expense related to prior periods and charged to license and patent disputes. The remaining $5.6 million was capitalized as the cost of the license and will be amortized to cost of product sales over the remaining life of the Roche patents, the last of which expires in June 2013.
NOTE 3. Distribution and Biosite Discovery Collaborative Agreements
Distribution Agreements
We have a distribution agreement under which Fisher distributes our products primarily to hospitals within the United States. The term of our distribution agreement with Fisher expires on December 31, 2008. Under the agreement, Fisher’s distribution rights are semi-exclusive in the U.S. hospital market and non-exclusive in the U.S. physician office market. Either party has the right to terminate the agreement in the case of an uncured breach by the other party. In addition, under certain circumstances, the distribution relationship may become non-exclusive or terminate with prior notice. For instance, if our direct sales to customers in the U.S. hospital market during a six month period exceed a specified percentage of the total sales of our products by both us and Fisher in that market segment, Fisher will have the option of converting the agreement to a mutually non-exclusive arrangement. The specified percentage of direct sales in the contract that would trigger this option far exceeds the current level of direct sales. If Fisher were to exercise the option, either party would have the ability to terminate the agreement upon prior notice to the other party. Similarly, if Fisher elects to promote and sell certain products that are competitive with our products, then we will have the option of converting the agreement to a mutually non-exclusive arrangement. If we were to exercise that option, either party would have the ability to terminate the agreement upon prior notice to the other party. Sales to Fisher represented 81%, 84% and 86% of our product sales in 2006, 2005 and 2004, respectively.
We also have distributor agreements with PSS and Henry Schein to market our products to physician office practices in the United States. Internationally, in addition to utilizing a direct sales force in certain countries, we sell our products to country-specific and regional distributors.
Biosite Discovery
In 1999, we launched Biosite Discovery, a research program dedicated to the identification of new protein targets for acute diseases. Through Biosite Discovery, we conduct analyses on both known proteins that may be markers of disease and proteins accessed from clinical and commercial collaborators in order to determine their diagnostic utility. We offer antibody development services to pharmaceutical and biotechnology companies seeking high-affinity antibodies for use in their drug research. In return, we seek diagnostic licenses to their targets, as well as other potential fees. Among the payments we might receive are: up-front technology access fees, antibody development fees upon the delivery of antibodies, annual maintenance fees on targets for which we have produced antibodies for as long as the targets remain in our collaborator’s drug development program, milestone fees on targets that reach certain clinical milestones and royalties should products successfully be commercialized as a result of the collaboration. Under Biosite Discovery, we have executed agreements with different commercial and clinical collaborators, and we have executed several license or cross-license agreements with other companies.
During 2006, 2005 and 2004, we recognized contract revenues of $5.3 million, $4.9 million and $4.3 million, respectively, related to activities performed or milestones achieved under the collaborative agreements. Under the terms of our agreement with Medarex, Inc., we receive research funding of $3.0 million per year. Our alliance with Medarex expires in May 2008. Costs of the research and development resources performing collaborative and internal Biosite Discovery activities in 2006, 2005 and 2004 were approximately $8.9 million, $8.0 million and $6.5 million, respectively, and are included in research and development expenses.
NOTE 4. Cash, Cash Equivalents and Marketable Securities
The following is a summary of cash, cash equivalents and marketable securities by balance sheet classification at December 31, 2006 (in thousands):
The following is a summary of cash, cash equivalents and marketable securities by balance sheet classification at December 31, 2005 (in thousands):
The amortized cost and estimated fair values of available-for-sale marketable securities at December 31, 2006, by contractual maturity, are as follows (in thousands):
Gross realized gains from the sale of cash equivalents and marketable securities were approximately $83,000, $1,000 and $14,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Gross realized losses from the sale of cash equivalents and marketable securities were approximately $294,000, $0 and $6,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
NOTE 5. Balance Sheet Information
Net inventories consist of the following (in thousands):
Property and equipment consist of the following (in thousands):
Depreciation expense was approximately $16.8 million, $13.7 million and $15.4 million for the years ended December 31, 2006, 2005 and 2004, respectively. Cost of equipment under equipment financing notes was approximately $28.4 million and $30.3 million at December 31, 2006 and 2005, respectively. Accumulated depreciation of equipment under equipment financing notes at December 31, 2006 and 2005 was approximately $18.0 million and $14.0 million, respectively.
NOTE 6. Debt and Commitments
Debt consisted of the following (in thousands):
As of December 31, 2006, approximate future principal payments of the equipment financing notes are due as follows: 2007 - $5.6 million; 2008 - $4.0 million; 2009 - $1.2 million; 2010 - $115,000; and thereafter - $0.
Interest expense was approximately $557,000 for the year ended December 31, 2006. From July 2003 to February 2006, interest incurred was capitalized as part of the costs of our new corporate complex. For the years ended December 31, 2006, 2005 and 2004, we incurred and capitalized interest totaling $139,000, $913,000 and $1.0 million, respectively.
We lease certain office facilities and automobiles under operating leases. The minimum annual rent on the facilities may be subject to increases based on changes in the Consumer Price Index, taxes, insurance and operating costs, subject to certain minimum and maximum annual increases. We record rent expense on a straight-line basis over the term of the leases.
Approximate annual future minimum operating lease payments as of December 31, 2006 are as follows (in thousands):
Rent expense for the years ended December 31, 2006, 2005 and 2004 was approximately $1.2 million, $2.5 million and $2.5 million, respectively.
In December 2006, we entered into an agreement to lease approximately 17.2 acres of land adjacent to our current San Diego corporate complex. The lease is effective February 1, 2007 and expires January 31, 2012, subject to certain early termination rights. Under this agreement, in consideration for an annual non-refundable option payment of $500,000, we also have an option to purchase this property at any time between September 1, 2007 and August 31, 2009. If we elect to exercise the purchase option, the purchase price for the property will be equal to 97% of its fair market value at the time that we exercise the option, but in any event not more than approximately $33.7 million and not less than approximately $26.1 million, and any option payments will be applied to the final purchase price for the property.
In September 2006, we completed our purchase of a facility in San Clemente, California for $6.4 million. The facility is approximately 38,000 square feet and will be utilized primarily to manufacture plastic parts for our diagnostic test kits. We are currently making improvements to the facility and installing equipment needed for its operation. Pending the completion of those tasks and the recruitment and training of additional personnel, we expect manufacturing operations to commence at the San Clemente facility in the first half of 2007.
In October 2003, we completed our purchase of approximately 26.1 usable acres of land for the construction of our corporate complex. This land provides us with the potential for up to 800,000 square feet of space, to be constructed in phases as needed. The first phase, which is now complete, provides us with approximately 350,000 square feet of space. The total cost of the land and the construction of the first phase was approximately $110.0 million. We have relocated all of our operations to the new corporate complex. From time to time we will
continue to evaluate the need to commence the next phase of construction of our corporate complex. We also will continue to evaluate the purchase of additional land or improved facilities to meet our future business needs. We expect our future occupancy costs to increase primarily due to increased square footage for our operations.
NOTE 7. Stockholders’ Equity
Stock Repurchase Programs. In October 2006, our Board of Directors approved a $100.0 million stock repurchase program. In connection with this stock repurchase program, we entered into a privately negotiated transaction with Goldman, Sachs & Co. to repurchase $100.0 million of our common stock. The agreement includes collar provisions that establish the minimum and maximum numbers of shares to be repurchased. The specific number of shares to be repurchased is generally based on the volume-weighted average share price of our common shares during the six to nine-month term of the accelerated repurchase agreement, subject to collar limits. In the fourth quarter of 2006, we paid Goldman Sachs $100.0 million in exchange for 1.9 million shares that were received and retired. This repurchase was made using our own cash reserves. Upon termination of the program in July 2007, we may be entitled to additional shares subject to the collar provisions.
During the quarter ended March 31, 2006, we repurchased an aggregate of 575,899 shares of our common stock at a total cost of approximately $30.0 million, including commissions. These repurchases were made using our own cash reserves.
Stock Plans In December 1996, we adopted the 1996 Stock Incentive Plan (the “1996 Stock Plan”). The 1996 Stock Plan replaced our 1989 Stock Plan. Although future awards will be made under the 1996 Stock Plan, awards made under the 1989 Stock Plan will continue to be administered in accordance with the 1989 Stock Plan. The 1996 Stock Plan provides for awards in the form of restricted shares, stock units, options or stock appreciation rights or any combination thereof. The aggregate number of shares authorized for issuance under the 1996 Stock Plan as of December 31, 2006 was 7,000,000 shares. Furthermore, as of December 31, 2006 there were an additional 142,421 shares of common stock available for issuance under the 1996 Stock Plan that were previously authorized, but never issued, under the 1989 Stock Plan.
In November 2002, the Board of Directors adopted the Biosite Incorporated 2002 Nonqualified Stock Incentive Plan (the “2002 Stock Plan”). The Board of Directors adopted the plan to accommodate Biosite’s continuing growth and expansion. The aggregate number of shares authorized for issuance under the 2002 Stock Plan as of December 31, 2006 was 1,450,000 shares, of which 900,000 shares are solely for use as inducement awards in connection with the recruitment of employees.
Options granted under the stock plans are generally subject to four-year vesting, on a daily or quarterly basis, and expire ten years from the date of grant. As of December 31, 2006, no shares were available for future issuance under the 1989 Stock Plan, 278,143 shares were available for future issuance under the 1996 Stock Plan and 85,137 shares were available for future issuance under the 2002 Stock Plan.
Information under FAS 123(R) for 2006
Information with respect to option activity under our stock option plans for 2006 is as follows:
The aggregate intrinsic value represents the excess of our closing stock price on the last trading day of the quarter, December 29, 2006, which was $48.85, over the exercise price of each lower-priced option multiplied by the number of shares of each lower-priced option. The total intrinsic value of options exercised was $14.7 million for 2006.
The following is a further breakdown of the options outstanding under the 1989 Stock Plan, 1996 Stock Plan and 2002 Stock Plan as of December 31, 2006 (option amounts in thousands):
Information under FAS 123 for Periods Prior to 2006
Information with respect to option activity under our stock plans for 2005 and 2004 is as follows:
The total intrinsic value of options exercised was $35.1 million and $15.3 million for 2005 and 2004, respectively.
Employee Stock Purchase Plan In December 1996, we adopted an ESPP which provides all qualifying employees the opportunity to purchase common stock at a discount and pay for such purchases through payroll deductions, subject to certain limitations. As of December 31, 2006, a pool of 1,100,000 shares of common stock has been reserved for issuance under the ESPP (subject to anti-dilution provisions). The ESPP includes an evergreen provision under which, for a period of ten years beginning on January 1, 2005, an increase in the pool of shares of common stock available for issuance under the ESPP occurs annually equal to the lesser of 1) one and one-half percent of the common shares outstanding at the end of the prior year; or 2) 1,500,000 shares of common stock; provided, however, that in no event shall the annual increase cause the shares available for purchase under the ESPP to exceed 5% of our outstanding common shares at the end of the prior year. Under the evergreen provision, the pool of shares of common stock available for issuance under the ESPP was increased by 237,950 shares on January 1, 2007. Shares are issued on the ESPP purchase dates, which are June 30 and December 31. During the years ended December 31, 2006, 2005 and 2004, 107,288, 125,285 and 141,631 shares were issued under the ESPP, respectively. As of December 31, 2006, 166,801 shares of common stock were available for issuance under the ESPP.
At December 31, 2006, a total of 530,081 shares of our common stock were reserved for future issuances under all of our stock plans and the ESPP.
Stockholder Rights Plan In October 1997, our Board of Directors declared a dividend distribution of one preferred stock purchase right (a “Right”) for each outstanding share of common stock of Biosite held of record at the close of business on November 3, 1997. Each Right represents a contingent right to purchase, under certain circumstances, one-one-thousandth of a share of a new series of Biosite preferred stock at a price of $100.00 per one one-thousandth of a share, subject to adjustment. The Rights would be traded independently from Biosite’s common stock and become exercisable under certain circumstances involving the acquisition or a tender or exchange offer by a person or group for 15% or more of Biosite’s common stock. The Rights expire on June 1, 2011, unless redeemed by our Board of Directors. The Rights can be redeemed by the Board at a price of $0.01 per Right at any time before the Rights become exercisable, and in limited circumstances thereafter.
NOTE 8. Income Taxes
Significant components of the income tax provision are as follows (in thousands):
Significant components of our net deferred tax assets as of December 31, 2006 and 2005 are as follows (in thousands):
As of December 31, 2006, we had $150,000 of California research and development credit carryforwards. These carryovers do not expire. We also had foreign net operating loss carryovers of approximately $1.6 million. These carryovers begin to expire in 2010.
No valuation allowance has been recorded to offset the deferred tax assets as the Company has determined that it is more likely than not that such assets will be realized. We will continue to assess the likelihood of realization of such assets; however, if future events occur which do not make the realization of such assets more likely than not, we will record a valuation allowance against all or a portion of the net deferred tax assets.
The reconciliation of the federal statutory tax rate to our effective tax rate is as follows:
It is our policy to record tax benefits only if we conclude that it is at least probable that the deduction or credit will be sustained upon examination by tax authorities. In the period that permanent tax benefits, including research and development tax credits, are generated, we recognize the tax benefits at their estimated net realizable value. With regard to research tax credits, the determination of qualified expenses and activities involves judgment. Tax authorities have regularly examined and challenged research and development tax credits claimed by companies and have disallowed tax credit amounts based on the tax authorities’ evaluation and judgment. We reduce tax benefits to their estimated net realizable value based upon management’s assessment of exposure associated with permanent tax differences, tax credits and interest expense applied to temporary difference adjustments. The tax benefits are analyzed periodically and adjustments are made as events occur to warrant adjustments to the estimate of the net realizable value of the tax benefits.
During 2006, we finalized audits with both the Internal Revenue Service (years through 2004) and the California Franchise Tax Board (years through 2003). The favorable conclusion of these audits resulted in a release of amounts reserved for exposures mentioned above, of which approximately $1,900,000 reduced our income tax expense.
As of December 31, 2006, we had approximately $3,500,000 of undistributed earnings related to our foreign subsidiaries. Management believes that these earnings will be indefinitely reinvested; accordingly, we have not provided for U.S. federal income taxes related to these earnings. However, upon distribution of these earnings in the form of dividends or otherwise, we would be subject to both U.S. income taxes and withholding taxes payable to the various foreign countries.
NOTE 9. Employee Savings Plans
Employee 401(k) Plan
In 1991, we implemented a 401(k) program that allows all qualifying employees to contribute up to a maximum of 20% of their annual salary, subject to annual limits. The Board of Directors may, at its sole discretion, approve contributions by Biosite. No such contributions have been approved or made.
Nonqualified Deferred Compensation Plan
In March 2005, we completed the implementation of a 409A Nonqualified Deferred Compensation Plan, or the Plan, for the benefit of a select group of our management or highly compensated employees, including our executive officers. The Plan is intended to comply with Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”). The Plan is an unfunded arrangement and any assets that may be set aside to finance the benefit promise are subject to the claims of our general creditors in the event of bankruptcy. The Plan is also intended to be exempt from the requirements of Parts 2, 3 and 4 (relating to participation, vesting, funding and fiduciary requirements) of Title I of the Employee Retirement Income Security Act of 1974, as amended, or ERISA. The deferred compensation balance at December 31, 2006 and 2005 was approximately $2.9 million and $2.5 million, respectively.
A participant in the Plan may annually elect to defer up to 25% of their base salary, and 100% of bonuses and/or commissions. The deferred compensation is contributed to either an investment designated as retirement account or an in-service account established by the participant at the time the deferral election is made. These marketable securities investments are classified as trading securities. We may also make discretionary contributions to participants’
accounts in the future, although we do not currently do so. Amounts contributed to participants’ accounts through participant deferrals or through our discretionary contributions are generally not subject to income tax until they are distributed from the accounts. All contributions made by participants are vested immediately. Any discretionary contributions made by us in the future, if any, are subject to such vesting arrangements as we may determine.
Amounts credited to a retirement account are distributed upon the retirement of a participant, in a lump sum or in annual installments during a specified number of years after retirement. Amounts credited to an in-service account are distributed at the beginning of a year selected by the participant that is no sooner than a specified number of years after the year the deferral election is made, in a lump sum or in annual installments during a specified number of years after the initial distribution. In the event of a participant’s disability, death or, subject to certain limitations set forth in the Plan, a participant’s termination of employment, all amounts credited to his or her account are distributed immediately in a lump sum. Early distributions may be permitted in the event of unforeseeable emergencies. A participant may from time to time designate one or more persons as his or her beneficiaries entitled to receive distributions under the Plan.
The Plan may be amended or terminated by our Board of Directors at any time, although no such amendment or termination may deprive a participant of any rights accrued under the Plan prior to the date of the amendment or termination. Other amendments may be made to conform the Plan to the provisions of applicable law, including the Code and ERISA.
NOTE 10. License and Patent Disputes
Expenses associated with license and patent disputes incurred during the years ended December 31, 2006, 2005 and 2004 totaled $3.1 million, $2.0 million and $178,000, respectively. The expenses in 2006 consisted of legal costs and $2.9 million of the $8.5 million settlement payment related to our litigation with Roche Diagnostics Corporation and its affiliates (see Note 2).
In November 2004, Roche Diagnostics Corporation, together with certain of its affiliates, filed a complaint in the United States District Court, Southern District of Indiana, Indianapolis Division alleging that we infringed two patents, U.S. Patent 5,366,609 and U.S. Patent 4,816,224, owned by Roche and/or its affiliates (the “Indiana Case”). Also, in November 2004, we filed a complaint in the United States District Court, Southern District of California alleging that Roche Diagnostics Corporation and Roche Diagnostics GmbH infringed two patents, U.S. Patent 6,174,686 and U.S. Patent 5,795,725, owned by us. We later amended our complaint to also allege infringement of one additional patent owned by us, U.S. Patent 6,939,678 (the “California Case”).
On July 26, 2006, we and Roche announced that we have entered into an agreement to settle both the Indiana Case and the California Case. The settlement involved a worldwide, royalty-free, non-exclusive cross-license of the patents involved in the two cases. Under the terms of the settlement agreement, both parties dismissed our respective complaints in the Indiana Case and the California Case. In addition, we made a one-time license payment of $8.5 million to Roche in the fourth quarter of 2006. Of the $8.5 million license payment, $2.9 million was recognized in the second quarter of 2006 as license amortization expense related to prior periods and charged to license and patent disputes. The remaining $5.6 million will be charged to cost of product sales over the remaining life of the Roche patents.
NOTE 11. Quarterly Information (Unaudited)
The following quarterly information includes all adjustments which management considers necessary for a fair statement of such information. For interim quarterly financial statements, the provision for income taxes is estimated using the best available information for projected results for the entire year.
Schedule II
Biosite Incorporated
Valuation and Qualifying Accounts
Years ended December 31, 2006, 2005 and 2004
(1) Uncollectible accounts written off, net of recoveries
(2) Write off of obsolete, excess or impaired inventory
(3) Cost incurred associated with the replacement and repair of the Triage Meters and devices