##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended June 30, 2004
 OR [   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from __________ to _____________
 Commission File Number: 000-50786 STRATAGENE CORPORATION  Delaware
    
    33-0683641(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 11011 North Torrey Pines Road, La Jolla, CA 92037(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code (858) 535-5400 No Change
(Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [   ] No [X] Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date. Class
    
    Outstanding at August 6, 2004Common Stock, $0.0001 Par Value
    
    21,916,183




---



STRATAGENE CORPORATION Quarterly Report on Form 10-Q
Table of Contents PagePart I. Financial InformationItem 1. Financial Statements
    
    
    3Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003 (unaudited)
    
    
    3Consolidated Income Statements for the Three and Six Months Ended June 30, 2004 (unaudited) and
2003 (as restated) (unaudited)
    
    
    4Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 (unaudited) and
2003 (as restated) (unaudited)
    
    
    5Notes to Unaudited Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    36Item 4. Controls and Procedures
    
    
    38Part II. Other Information
    
    
    39Item 1. Legal Proceedings
    
    
    39Item 4. Submission of Matters to a Vote of Security Holders
    
    
    39Item 6. Exhibits and Reports on Form 8-K
    
    
    40Signatures
    
    
    41EXHIBIT 3.1EXHIBIT 3.2EXHIBIT 4.1EXHIBIT 10.17EXHIBIT 10.18EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  Note: Items 2, 3 and 5 of Part II are omitted because they are not applicable. 2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 ITEM I. FINANCIAL STATEMENTS STRATAGENE CORPORATION AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
 (unaudited)
 June 30, 2004
    
    December 31, 2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    7,608,660
    
    
    $
    2,003,762Marketable debt securities
    
    
    904,887
    
    
    
    Cash  restricted related to bond indenture
    
    
    222,181
    
    
    
    658,587Foreign currency exchange contracts
    
    
    252,068
    
    
    
    205,110Accounts receivable, less allowance for doubtful
accounts of $783,501 at June 30, 2004 and $990,849 at
December 31, 2003
    
    
    11,067,592
    
    
    
    8,390,326Inventories
    
    
    12,229,317
    
    
    
    7,729,655Deferred income tax assets
    
    
    2,404,859
    
    
    
    1,711,947Due from related party, current
    
    
    
    
    
    
    265,639Prepaid expenses and other current assets
    
    
    1,924,514
    
    
    
    2,702,233Total current assets
    
    
    36,614,078
    
    
    
    23,667,259Property and equipment, net
    
    
    11,959,521
    
    
    
    10,320,992Other assets
    
    
    565,586
    
    
    
    696,858Due from related party
    
    
    291,360
    
    
    
    451,630Deferred income tax assets
    
    
    695,880
    
    
    
    Goodwill
    
    
    27,853,723
    
    
    
    Intangible assets, net
    
    
    6,530,787
    
    
    
    2,984,009Investment in joint venture
    
    
    1,228,717
    
    
    
    467,109Total assets
    
    $
    85,739,652
    
    
    $
    38,587,857LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    4,549,475
    
    
    $
    5,003,788Accrued expenses and other liabilities
    
    
    8,133,798
    
    
    
    5,332,114Current portion of long-term debt
    
    
    3,587,033
    
    
    
    920,062Due to related party, current
    
    
    491,448
    
    
    
    268,200Deferred revenue, current
    
    
    823,835
    
    
    
    1,491,976Income taxes payable
    
    
    1,616,296
    
    
    
    1,165,663Total current liabilities
    
    
    19,201,885
    
    
    
    14,181,803Deferred revenue
    
    
    451,732
    
    
    
    Long-term debt, less current portion
    
    
    15,154,874
    
    
    
    29,461,617Due to related party
    
    
    1,178,092
    
    
    
    Deferred income tax liabilities
    
    
    
    
    
    
    891,179Total liabilities
    
    
    35,986,583
    
    
    
    44,534,599Commitments and contingencies (Note 9)Stockholders equity (deficit):Preferred stock, $.0001 par value; 4,000,000 shares
authorized; no shares issued and outstanding at June 30,
2004 and December 31, 2003
    
    
    
    
    
    
    Common stock, $.0001 par value; 50,000,000 shares
authorized; 21,879,861 and 15,632,668 shares issued and
outstanding at June 30, 2004 and December 31, 2003,
respectively
    
    
    2,188
    
    
    
    1,563Additional paid-in capital
    
    
    52,304,488
    
    
    
    1,821,202Stock-based compensation
    
    
    (732,915
    )
    
    
    Accumulated deficit
    
    
    (390,431
    )
    
    
    (3,447,340
    )Notes receivable from stockholders
    
    
    (148,616
    )
    
    
    (3,356,309
    )Bond market valuation
    
    
    733
    
    
    
    Accumulated other comprehensive loss
    
    
    (1,282,378
    )
    
    
    (940,514
    )Total stockholders equity (deficit)
    
    
    49,753,069
    
    
    
    (5,921,398
    )Treasury stock, at cost; no shares at June 30, 2004 and
7,040 shares at December 31, 2003
    
    
    
    
    
    
    (25,344
    )Total stockholders equity (deficit)
    
    
    49,753,069
    
    
    
    (5,946,742
    )Total liabilities and stockholders equity (deficit)
    
    $
    85,739,652
    
    
    $
    38,587,857
 See accompanying notes to unaudited consolidated financial statements. 3




---



##### Table of Contents



STRATAGENE CORPORATION AND SUBSIDIARIES 
 CONSOLIDATED INCOME STATEMENTS
 (unaudited)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(As restated,
    
    
    
    
    
    (As restated,Note 13)
    
    
    
    
    
    Note 13)Product sales
    
    $
    19,746,529
    
    
    $
    17,025,245
    
    
    $
    39,168,551
    
    
    $
    33,900,903Costs and expenses:Cost of products sold
    
    
    7,125,210
    
    
    
    5,233,624
    
    
    
    13,050,795
    
    
    
    10,526,453Research and development
    
    
    2,811,237
    
    
    
    2,753,982
    
    
    
    5,331,850
    
    
    
    5,592,141Selling and marketing
    
    
    4,269,205
    
    
    
    3,585,114
    
    
    
    8,323,668
    
    
    
    7,570,816General and administrative
    
    
    5,469,654
    
    
    
    2,701,494
    
    
    
    8,563,521
    
    
    
    5,027,352Impairment of long-lived assets
    
    
    6,893
    
    
    
    
    
    
    
    58,131
    
    
    
    Total costs and expenses
    
    
    19,682,199
    
    
    
    14,274,214
    
    
    
    35,327,965
    
    
    
    28,716,762Income from operations
    
    
    64,330
    
    
    
    2,751,031
    
    
    
    3,840,586
    
    
    
    5,184,141Other income and expenses:Gain (loss) on foreign currency transactions
    
    
    46,051
    
    
    
    (206,821
    )
    
    
    (83,250
    )
    
    
    (48,295
    )Equity in income (loss) of joint venture
    
    
    1,785,822
    
    
    
    (36,873
    )
    
    
    1,761,608
    
    
    
    (84,510
    )Other income (loss), net
    
    
    (1,417
    )
    
    
    3,105
    
    
    
    83,345
    
    
    
    7,406Interest expense
    
    
    (497,514
    )
    
    
    (903,812
    )
    
    
    (1,191,287
    )
    
    
    (1,566,436
    )Interest income
    
    
    48,565
    
    
    
    58,707
    
    
    
    116,043
    
    
    
    117,354Total other income (expense)
    
    
    1,381,507
    
    
    
    (1,085,694
    )
    
    
    686,459
    
    
    
    (1,574,481
    )Income before income taxes
    
    
    1,445,837
    
    
    
    1,665,337
    
    
    
    4,527,045
    
    
    
    3,609,660Income tax (expense) benefit
    
    
    13,440
    
    
    
    (533,140
    )
    
    
    (993,856
    )
    
    
    (1,202,788
    )Net income
    
    $
    1,459,277
    
    
    $
    1,132,197
    
    
    $
    3,533,189
    
    
    $
    2,406,872Earnings per share:Basic
    
    $
    0.08
    
    
    $
    0.07
    
    
    $
    0.21
    
    
    $
    0.15Diluted
    
    $
    0.08
    
    
    $
    0.07
    
    
    $
    0.21
    
    
    $
    0.15Weighted average shares:Basic
    
    
    17,581,384
    
    
    
    15,632,668
    
    
    
    16,607,026
    
    
    
    15,632,668Diluted
    
    
    17,655,091
    
    
    
    15,632,668
    
    
    
    16,639,932
    
    
    
    15,632,668
 See accompanying notes to unaudited consolidated financial statements. 4




---



##### Table of Contents



STRATAGENE CORPORATION AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (unaudited)
 Six Months EndedJune 30,2004
    
    2003(As restated,Note 13)Cash flows from operating activities:Net income
    
    $
    3,533,189
    
    
    $
    2,406,872Adjustments to reconcile net income to net cash
provided by operating activities:Equity in (income) loss of joint venture
    
    
    (1,761,608
    )
    
    
    84,510Depreciation and amortization
    
    
    1,347,191
    
    
    
    1,391,879Impairment of long-lived assets
    
    
    58,131
    
    
    
    Stock compensation
    
    
    449,522
    
    
    
    Bad debt expense
    
    
    (155,132
    )
    
    
    80,130Excess and obsolete expense
    
    
    233,049
    
    
    
    (79,815
    )Loss on disposal of assets
    
    
    
    
    
    
    860Interest accrued on notes receivable from stockholders
    
    
    (81,488
    )
    
    
    (87,172
    )Accretion of interest on long-term debt
    
    
    740,842
    
    
    
    1,423,187Deferred income taxes
    
    
    (691,435
    )
    
    
    242,788Changes in assets and liabilities (net of impact
of merger with Hycor):Foreign currency exchange contracts
    
    
    (46,958
    )
    
    
    (111,159
    )Accounts receivable
    
    
    396,978
    
    
    
    (1,353,492
    )Inventories
    
    
    (60,643
    )
    
    
    75,375Prepaid expenses and other current assets
    
    
    1,026,956
    
    
    
    (536,001
    )Due from related party
    
    
    44,523
    
    
    
    (76,678
    )Due to related party
    
    
    1,401,340
    
    
    
    Income taxes receivable
    
    
    (15,283
    )
    
    
    Other assets
    
    
    166,683
    
    
    
    189,795Accounts payable
    
    
    (917,901
    )
    
    
    (448,742
    )Accrued expenses and other liabilities
    
    
    (1,223,098
    )
    
    
    144,223Deferred revenue
    
    
    (206,990
    )
    
    
    69,624Income taxes payable
    
    
    133,673
    
    
    
    709,783Net cash provided by operating activities
    
    
    4,371,541
    
    
    
    4,125,966Cash flows from investing activities:Cash acquired in merger, net of acquisition costs
    
    
    4,520,153
    
    
    
    Purchases of property and equipment
    
    
    (395,978
    )
    
    
    (551,443
    )Additions to intangible assets
    
    
    (684,611
    )
    
    
    (485,269
    )Redemption of BCH member interests
    
    
    (7,378
    )
    
    
    Changes in restricted cash
    
    
    435,174
    
    
    
    456,627Cash distributions from joint venture
    
    
    1,000,000
    
    
    
    Net cash (used in) provided by investing activities
    
    
    4,867,360
    
    
    
    (580,085
    )
 (Continued) 5




---



##### Table of Contents



STRATAGENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited) Six Months EndedJune 30,2004
    
    2003(As restated,Note 13)Cash flows from financing activities:Principal payments on long-term debt
    
    
    (17,340,806
    )
    
    
    (2,016,542
    )Issuance of long-term debt
    
    
    6,000,000
    
    
    
    637,500Borrowings under line of credit
    
    
    8,128,953
    
    
    
    450,000Payments under line of credit
    
    
    
    
    
    
    (450,000
    )Distributions to BCH members
    
    
    (476,280
    )
    
    
    (242,568
    )Net cash used in financing activities
    
    
    (3,688,133
    )
    
    
    (1,621,610
    )Effects of foreign currency exchange rates on cash
    
    
    54,130
    
    
    
    (503,643
    )Net increase in cash
    
    
    5,604,898
    
    
    
    1,420,628Cash at beginning of period
    
    
    2,003,762
    
    
    
    1,207,892Cash at end of period
    
    $
    7,608,660
    
    
    $
    2,628,520Supplemental disclosure of cash flow information:Cash paid during the period for:Interest
    
    $
    394,746
    
    
    $
    170,522Income taxes
    
    $
    1,065,580
    
    
    $
    296,466Non-cash financing activities:Shares of common stock issued in exchange for
the outstanding shares of Hycor
and fair value of $3,331,223 assigned to the
Hycor options assumed
    
    $
    43,972,844
    
    
    $
    Shares of common stock issued with respect to
the conversion of outstanding debt
    
    $
    9,180,000
    
    
    $
    Redemption of common stock for outstanding
notes receivable from stockholder
    
    $
    (2,899,181
    )
    
    $
    Redemption of common stock for outstanding
note receivable from stockholder
    
    $
    (276,878
    )
    
    $
    Common stock issued in cashless exercises
    
    $
    15
    
    
    $
    Deferred taxes recorded in connection with
BCH asset purchase
    
    $
    750,000
    
    
    $
    
 (Concluded) See accompanying notes to unaudited consolidated financial statements. 6




---



##### Table of Contents



STRATAGENE CORPORATION AND SUBSIDIARIES 
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2004 1. Basis of Presentation The consolidated financial statements of Stratagene Corporation and its
subsidiaries (Stratagene or the Company) for the three and six months ended
June 30, 2004 and 2003 are unaudited. These financial statements include all
adjustments that, in the opinion of management, are necessary to present fairly
the consolidated financial position of the Company as of June 30, 2004 and the
consolidated results of operations and cash flows of the Company for the three
and six months ended June 30, 2004 and 2003. The financial information of the Company has been presented on a
consolidated basis, and includes the results of operations of Hycor Biomedical
Inc. and subsidiaries (Hycor) since Hycor was acquired by the Company on June
2, 2004. The financial information also includes the results of operations of
BioCrest Holdings, LLC (BCH), whose assets were acquired by the Company on
June 2, 2004. Prior to the acquisition, BCH was under common control with
Stratagene, and substantially all of the BCH membership units were held by
certain Stratagene shareholders. The acquisition of the BCH assets has been
presented as a change in reporting entity. Accordingly, the financial
statements of Stratagene and BCH are presented on a consolidated basis for all
periods. (See Note 2.) Intercompany balances and transactions have been
eliminated as appropriate in the consolidation of Stratagene. Certain items in the consolidated financial statements have been
reclassified to conform to the current period presentation. The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the consolidated
financial statements and disclosures made in the accompanying notes. Actual
results could differ from those estimates. Stratagene accounts for marketable securities pursuant to Statement of
Financial Accounting Standards (SFAS) No. 115, Accounting for Certain
Investments in Debt and Equity Securities.At June 30, 2004 and December 31,
2003, marketable debt securities have been categorized as available for sale
and, as a result, are stated at fair value. Marketable debt securities
available for current operations are classified in the consolidated balance
sheet as current assets. Unrealized holding gains and losses are included as a
component of accumulated other comprehensive income (loss), net of tax, until
realized. These statements have been prepared pursuant to the rules and regulations
of the Securities and Exchange
Commission (SEC) and do not include all the information and note disclosures required
by accounting principles generally accepted in the United States of America for
complete financial statements but reflect all adjustments (consisting only of
normal recurring accruals, except as disclosed herein) necessary for the fair
presentation of the financial position, results of operations and cash flows
for the periods and dates presented. These consolidated financial statements
should be read in conjunction with the combined financial statements and
related notes included in Amendment No. 3 to the registration statement on Form
S-4 filed by Stratagene on April 29, 2004 with the SEC. The results of operations for any interim period are not necessarily
indicative of results to be expected for the full year. 2. Business Combinations Hycor Merger On June 2, 2004, Stratagene acquired all of the outstanding shares of
Hycor through a merger of a wholly owned subsidiary of Stratagene with Hycor,
with Hycor surviving as a wholly owned subsidiary of Stratagene. Hycor engages
in researching, developing, manufacturing and marketing medical diagnostic
products throughout the United States and in many foreign countries. The
primary reasons for the merger were the following:  
    
    The combination of Stratagenes molecular diagnostics technology and
Hycors Good Manufacturing Practice (GMP) approved facilities and U.S.
Food and Drug Administration (FDA) experience allows the Company to
enter the molecular diagnostic market;
    
    Potential growth from increased earnings and revenue;
    
    Expanded access to capital markets; and
    
    Diversified customer base and product lines. 7




---



##### Table of Contents



As a result of the merger, Hycors former shareholders received 0.6158 of
a share of Stratagene common stock in exchange for each share of Hycor common
stock, plus cash for fractional shares. The fair value of the consideration
exchanged in the merger has been calculated based upon the fair value of
Hycors publicly-traded common shares, as their fair value was determined to be
more clearly evident than that of Stratagenes common shares. In accordance
with Emerging Issues Task Force (EITF) No. 99-12, Determining the Measurement
Date for the Market Price for an Acquirer of Securities Issued in a Business
Combination,the market price was determined based on an average of the closing
prices of the Hycor stock for the trading days nearest July 24, 2003, the date
on which the merger agreement was originally signed. Using the 0.6158 exchange
ratio, 5,015,453 shares of Stratagene common stock were issued to the former
Hycor stockholders in connection with the merger and approximately 655
fractional shares were redeemed through a cash payment by Stratagene. Stratagene has also assumed each outstanding option to purchase shares of
Hycor common stock issued under the stock option plans of Hycor, whether or not
then exercisable, on substantially the same terms and conditions as were
applicable prior to the merger date, except that  
    
    the options are exercisable for shares of Stratagene common stock,
and
    
    the number of shares of Stratagene common stock that may be purchased
are equal to the number of shares of Hycor common stock underlying the
option multiplied by 0.6158, rounded down to the nearest whole number. The stock option plans of Hycor include the following:  
    
    the Hycor Biomedical Inc. 2001 Stock Option Plan;
    
    the Hycor Biomedical Inc. 1992 Incentive Stock Plan; and
    
    the Hycor Biomedical Inc. Nonqualified Stock Option Plan for Non-Employee Directors, as amended. The exercise price per share for the Stratagene common stock issuable
under each Hycor option equals the per share exercise price of the Hycor common
stock purchasable under the Hycor option divided by the exchange ratio of
0.6158, rounded up to the nearest whole cent. Stratagene has reserved for issuance a number of shares of Stratagene
common stock at least equal to the number of shares of Stratagene common stock
that are subject to Stratagene options as a result of the assumption by
Stratagene of Hycor options as contemplated by the merger agreement. Stratagene
assumed options to purchase an aggregate of 756,822 shares of Stratagene common
stock in connection with the merger. The total purchase consideration for the acquisition of Hycor was
$45,714,053, based on the following components: Purchase consideration:Fair value of 5,015,453 Stratagene common shares issued at $8.10 per share
    
    $
    40,641,622Fair value of Hycor fractional shares acquired with cash
    
    
    6,120Fair value of Hycor common stock options assumed
    
    
    3,331,223Merger related costs
    
    
    1,735,088Total purchase consideration
    
    $
    45,714,053
 8




---



##### Table of Contents



The following represents an estimated allocation of the purchase price to
the acquired assets and the assumed liabilities of Hycor. Stratagene considered
a number of factors in its determination of the allocation of purchase price,
including the results of a third-party valuation. Stratagene has not yet
obtained all the information required to complete the purchase price allocation
related to the Hycor merger. The final allocation is expected to be completed
by the fourth quarter of 2004. Purchase price allocation:Current assets
    
    $
    15,631,593Property and equipment
    
    
    2,269,676Goodwill
    
    
    27,853,723Other non-amortizable intangible assets
    
    
    1,575,000Amortizable intangible assets
    
    
    1,669,000Unearned stock-based compensation for unvested stock options assumed
    
    
    781,622Deferred tax assets, net
    
    
    404,730Total assets acquired
    
    
    50,185,344Total liabilities assumed
    
    
    (4,471,291
    )Net assets acquired
    
    $
    45,714,053
 Goodwill represents the excess of the purchase price over the fair value
of the tangible and identifiable intangible assets. The other non-amortizable
intangible assets consist of $1,575,000 for a trade name with an indefinite
life. The amortizable intangible assets include $480,000 for patents and
trademarks, which will be amortized over 1 to 5 years, and $1,189,000 for
contractually based customer relationships, which will be amortized over 1 to 5
years. Unearned stock-based compensation for unvested Hycor stock options assumed
is the sum of the intrinsic value of each unvested stock option assumed by
Stratagene in the merger with Hycor. The unvested portion of the assumed
options will be amortized over the remaining vesting period using the graded
vesting method prescribed under Financial Interpretation No. 28, Accounting for
Stock Appreciation Rights and Other Variable Stock Option or Award Plans(FIN
No. 28). In connection with the merger, the following events occurred on June 2,
2004:  
    
    Stratagene forgave $390,000 of the shareholder note receivable due
to Stratagene by Dr. Joseph A. Sorge, Stratagenes Chief Executive
Officer (Dr. Sorge), and paid the income taxes related to the
forgiveness, which resulted in a charge to Stratagene of $650,000. This
forgiveness was applied to reduce the note receivable, which was
$3,351,311 at June 2, 2004, including interest. Dr. Sorge satisfied the
remaining portion of his shareholder note receivable on June 2, 2004 by
tendering an aggregate of 524,160 shares of common stock to Stratagene
at a price of approximately $6.50 per share. The share price was based
on Hycors stock price of approximately $4.00 at the time Stratagene
and Hycor agreed on the repurchase, adjusted for the exchange ratio.
    
    In addition, another shareholder paid off the balance of her note,
which was $276,877 at June 2, 2004, including interest, by tendering
42,623 shares of common stock to Stratagene at a price of approximately
$6.50 per share. This price was based on Hycors stock price of
approximately $4.00 at the time Stratagene and Hycor agreed on the
repurchase price, adjusted for the exchange ratio.
    
    Dr. Sorge received a bonus in the amount of approximately
$1,670,000, which will be paid pursuant to the terms of a promissory
note with a 39-month term and bearing interest at a rate of 3.89% per
annum. These amounts are included in due to related party on the
balance sheet.
    
    Stratagene entered into a new employment contract with Dr. Sorge,
pursuant to which, among other things, Dr. Sorges base annual salary
was reduced from $1.1 million to $450,000, and Dr. Sorge was granted an
option to purchase 738,960 shares of Stratagene common stock at an
exercise price of $9.34 per share. The contract provides for Dr.
Sorges base salary to be reviewed on at least an annual basis by the
compensation committee of the board of directors, which may also
increase Dr. Sorges base salary from time to time in its discretion.
It is anticipated that if the Company establishes any general bonus
program for senior executives based upon the attainment of established
goals, Dr. Sorge shall be entitled to participate in such program on a
basis at least comparable to other senior executives. Dr. Sorge may
also receive bonuses at the discretion of the board of directors upon
the recommendation of the compensation committee. The new employment
agreement has an initial term of three years and is subject to
successive one-year renewals unless either party provides a notice of
non-renewal at least 30 days prior to the termination of the then
current term.
    
    Stratagene converted $9.0 million in principal amount of the
subordinated notes, pursuant to their terms, into 1,753,604 shares of
Stratagene common stock. As a result of the conversion, there are no
subordinated notes outstanding subsequent to 9




---



##### Table of Contents



the merger. Pro Forma Information The results of operations of Hycor have been included in the accompanying
consolidated financial statements of Stratagene from the date of acquisition.
However, the following unaudited pro forma information assumes that the June 2,
2004 Hycor merger occurred on January 1, 2004 and 2003, respectively. These
unaudited pro forma results have been prepared for comparative purposes only
and are not indicative of the results of operations that would have actually
resulted had the acquisition been in effect as of the periods indicated above,
or of future results of operations. The unaudited pro forma results for the
three and six months ended June 30, 2004 and 2003 are as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    23,244,240
    
    
    $
    22,006,037
    
    
    $
    48,135,084
    
    
    $
    43,759,262Net income
    
    $
    2,073,109
    
    
    $
    1,537,481
    
    
    $
    4,810,746
    
    
    $
    3,161,398Earnings per share:Basic
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.22
    
    
    $
    0.14Diluted
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.22
    
    
    $
    0.14Weighted average shares:Basic
    
    
    21,880,045
    
    
    
    21,828,957
    
    
    
    21,852,158
    
    
    
    21,824,865Diluted
    
    
    22,184,693
    
    
    
    22,072,082
    
    
    
    22,139,438
    
    
    
    22,003,421
 The unaudited pro forma information presented above has been adjusted for
charges for material, nonrecurring items that include the following:  
    
    removing interest income on shareholder loans that were paid off upon the closing of the merger;
    
    removing interest expense on subordinated debt that converted to common stock upon the closing of the merger;
    
    recording amortization expense on acquired other intangible assets;
    
    recording amortization expense on unearned stock-based compensation for assumed stock options;
    
    reducing the CEOs salary pursuant to a new employment agreement effective on the merger date;
    
    removing Hycors merger related costs incurred in the periods presented; and
    
    recording the tax provision adjustment to the pro forma statement of operations at the statutory rate of 36%. BCH Acquisition Concurrently with the closing of the Hycor merger, Stratagene acquired
substantially all of the assets of BCH, including BCHs interests in its
subsidiaries. In exchange, Stratagene forgave all of the outstanding
intercompany indebtedness owed by BCH and its subsidiaries to Stratagene and
its subsidiaries of approximately $5.5 million and assumed all of the other
outstanding liabilities of BCH and its subsidiaries of approximately $0.8
million. Because Stratagene and BCH are under common control, and substantially
all of the BCH membership units are held by certain Stratagene shareholders,
the acquisition of BCH was recorded on a historical cost basis. As such, there
was no adjustment of BCHs assets and liabilities to fair value and no goodwill
resulting from the purchase. As of and for the periods ended June 30, 2004, the
financial statements are presented on a consolidated basis for Stratagene
Corporation, which represents a change in reporting entity under Accounting
Principles Board Opinion 20, Accounting Changes. Previously combined statements
are now presented on a consolidated basis as a result of the transaction. There
is no change to income for previous periods presented on a combined basis. For
tax purposes, this transaction is considered a taxable pooling. The financial
statements reflect net deferred tax assets of $750,000 for differences between
the tax and book basis of assets and liabilities acquired by Stratagene. Prior to the acquisition date, Stratagene presented its financial
statements on a combined basis with BCH. BCH consisted substantially of
limited liability companies that were treated as partnerships for income tax
purposes; therefore, any related income tax liabilities were the responsibility
of the members. As a result, the operations of BCH did not reflect a provision
for income taxes in the combined financial statements, including its share of
the $1.8 million gain in equity in earnings of joint venture on June 1, 2004.
Beginning on June 2, 2004, the consolidated results of Stratagene, which
includes the results of BCH, includes a provision for income taxes. As part of the BCH acquisition, Stratagene acquired BCHs interests in its
subsidiaries, which include Phenogenex, LLC (Phenogenex), Iobion Informatics,
LLC and subsidiaries (Iobion) and an investment in a joint venture consisting
of a 49% interest 10




---



##### Table of Contents



in a limited partnership that operates a research lab. The investment is
accounted for under the equity method. As a result of the acquisition, Stratagene owns 100% of Phenogenex and
approximately 78% of Iobion. The remaining 22% interest in Iobion is
represented by membership units held by two individuals who are consultants to
the Company. Gains, losses and cash flows are allocated in accordance with the
limited liability company (LLC) agreement, generally first to eliminate any
deficit in a members capital account, next to provide for a priority return to
Stratagene, and then in accordance with respective ownership percentages. For
the six months ended June 30, 2004 and 2003, Iobion has incurred losses of
approximately $147,000 and $477,000, respectively. As of June 30, 2004 and
December 31, 2003, Iobion had accumulated deficits of
approximately $707,000
and $696,000, respectively. None of the losses have been allocated to the
minority holders of the 22% interest, due to the fact that they did not fund
initial capital contributions and have no requirement to make future capital
contributions to Iobion. Accordingly, Stratagene has absorbed all losses
incurred since inception. 3. Earnings Per Share (EPS) Basic EPS is based on the weighted-average number of shares outstanding
during the periods, while diluted EPS additionally includes the dilutive
effects of the Companys outstanding options computed using the treasury stock
method. The number of shares used in computing EPS is as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Weighted average shares:Basic
    
    
    17,581,384
    
    
    
    15,632,668
    
    
    
    16,607,026
    
    
    
    15,632,668Effect of dilutive common stock options
    
    
    73,707
    
    
    
    
    
    
    
    32,906
    
    
    
    Diluted
    
    
    17,655,091
    
    
    
    15,632,668
    
    
    
    16,639,932
    
    
    
    15,632,668
 For both the three and six months ended June 30, 2004 and 2003, options
outstanding totaling 3,024,246 and 1,597,368 shares, respectively, were
excluded from the calculations of earnings per common share, as their effect
would have been antidilutive. 4. Accounting for Stock-Based Compensation The Company accounts for its stock-based compensation in accordance with
the provisions of Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees,as amended, and Financial Accounting
Standards Board (FASB) Interpretation No. 44, Accounting for Certain
Transactions Involving Stock Compensation. Pro forma information regarding net income is required by SFAS No. 123,
Accounting for Stock-based Compensation(SFAS No. 123), and has been
determined as if the Company had accounted for its employee stock options under
the fair value method of SFAS No. 123. Under SFAS No. 123, the fair value of
stock-based awards to employees is calculated through the use of option pricing
models, even though such models were developed to estimate the fair value of
freely tradable, fully transferable options without vesting restrictions, which
significantly differ from the Companys stock option awards. The fair value for
Stratagene employee stock options was estimated at the dates of grant using the
minimum value option pricing model from the stock option plan inception date
through June 2, 2004 and the Black-Scholes pricing model for all option grants
made subsequent to that date. Fair value for Hycor employee stock options was
estimated at the dates of grant using the Black-Scholes pricing model for all
option grants. The following weighted average assumptions were used for the
three and six month periods ended June 30, 2004 and 2003: 2004
    
    2003Risk free interest rate
    
    
    4.0
    %
    
    
    4.0
    %Dividend yield
    
    
    0
    %
    
    
    0
    %Volatility factor
    
    
    45
    %
    
    
    0
    %Expected life (in years)
    
    6 years
    
    6 yearsResulting average fair value
    
    $
    3.71
    
    
    $
    0.00
 11




---



##### Table of Contents



If the computed fair values of the stock options granted in 2004 and 2003
had been amortized to expense over the vesting period of the awards, pro forma
net income would have been as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income as reported
    
    $
    1,459,277
    
    
    $
    1,132,197
    
    
    $
    3,533,189
    
    
    $
    2,406,872Stock-based employee
compensation expense
included in reported net
income, net of related
tax effects
    
    
    70,640
    
    
    
    
    
    
    
    93,530
    
    
    
    Stock-based compensation
expense determined under
the fair value based
method for all awards,
net of related tax
effects
    
    
    (95,055
    )
    
    
    (1,774
    )
    
    
    (94,252
    )
    
    
    (1,624
    )Pro forma net income
    
    $
    1,434,862
    
    
    $
    1,130,423
    
    
    $
    3,532,467
    
    
    $
    2,405,248Earnings per common share:Basic  as reported
    
    $
    0.08
    
    
    $
    0.07
    
    
    $
    0.21
    
    
    $
    0.15Basic  pro forma
    
    $
    0.08
    
    
    $
    0.07
    
    
    $
    0.21
    
    
    $
    0.15Diluted  as reported
    
    $
    0.08
    
    
    $
    0.07
    
    
    $
    0.21
    
    
    $
    0.15Diluted  pro forma
    
    $
    0.08
    
    
    $
    0.07
    
    
    $
    0.21
    
    
    $
    0.15
 Charges for options granted to non-employees have been determined in
accordance with SFAS No. 123 and EITF No. 96-18, Accounting for Equity
Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services,as the estimated fair value of the
consideration received or the estimated fair value of the equity instruments
issued, whichever is more reliably measured. Deferred charges for options
granted to non-employees are periodically re-measured as the underlying options
vest and are included in additional paid-in capital in the financial
statements. 5. Balance Sheet Information Inventory Inventories are stated at the lower of cost or market. Cost is determined
on a first-in, first-out basis. Inventories consist of the following: June 30,
    
    December 31,2004
    
    2003Raw materials and supplies
    
    $
    5,668,139
    
    
    $
    4,314,445Work-in-process
    
    
    3,045,475
    
    
    
    1,612,335Finished goods
    
    
    3,515,703
    
    
    
    1,802,875Total
    
    $
    12,229,317
    
    
    $
    7,729,655
 Intangible Assets and Goodwill The following sets forth the intangible assets by major asset class: June 30, 2004
    
    December 31, 2003Useful Life
    
    
    
    
    
    Accumulated
    
    Net Book
    
    
    
    
    
    Accumulated
    
    Net Book(Years)
    
    Gross
    
    Amortization
    
    Value
    
    Gross
    
    Amortization
    
    ValueIntangible assets subject to amortization:Amortizable patents and other
    
    2  7 years
    
    $
    6,719,840
    
    
    $
    2,921,789
    
    
    $
    3,798,051
    
    
    $
    5,651,019
    
    
    $
    2,667,010
    
    
    $
    2,984,009Amortizable intangible assets
    
    1  5 years
    
    $
    1,189,000
    
    
    $
    31,264
    
    
    $
    1,157,736
    
    
    $
    
    
    
    $
    
    
    
    $
    Intangible assets not subject to amortization:Non-amortizable intangible assets
    
    
    
    
    
    $
    1,575,000
    
    
    $
    
    
    
    $
    1,575,000
    
    
    $
    
    
    
    $
    
    
    
    $
    Goodwill
    
    
    
    
    
    $
    27,853,723
    
    
    $
    
    
    
    $
    27,853,723
    
    
    $
    
    
    
    $
    
    
    
    $
    
 Amortizable patents and other includes costs incurred in connection with
patent applications which consist principally of legal fees. Amortizable intangible
assets, non-amortizable intangible assets and goodwill were established in
connection with the merger with Hycor (see Note 2). 12




---



##### Table of Contents



Amortization expense totaled $184,401 and $120,432 for the three months
ended June 30, 2004 and 2003, respectively. Amortization expense totaled
$286,043 and $237,674 for the six months ended June 30, 2004 and 2003,
respectively. Amortization expense in each of the next five fiscal years is
expected to be as follows: Year
    
    Amount2004
    
    $
    868,8762005
    
    
    1,002,8302006
    
    
    908,2232007
    
    
    758,8652008
    
    
    480,054Total
    
    $
    4,018,848
 Accrued Expenses and Other Liabilities Accrued expenses and other liabilities consist of the following: June 30,
    
    December 31,2004
    
    2003Accrued compensation
    
    $
    2,497,283
    
    
    $
    1,302,102Accrued royalties
    
    
    3,264,771
    
    
    
    2,310,744Warranty
    
    
    671,249
    
    
    
    596,788Accrued expenses and other liabilities
    
    
    1,700,495
    
    
    
    1,122,480Total
    
    $
    8,133,798
    
    
    $
    5,332,114
 6. Long-Term Debt and Line of Credit The Company has several debt instruments bearing interest at rates up to
7.5%, most of which are guaranteed by Stratagene and secured by substantially
all of the assets of Stratagene. Many of the instruments contain restrictive
covenants requiring the Company to maintain certain financial ratios, including
minimum debt service coverage ratios, fixed charge coverage ratios and tangible
net worth. The Company was in compliance with all covenants at June 30, 2004.
Long-term debt and line of credit consist of the following: June 30,
    
    December 31,2004
    
    2003Term loan in the amount of $6,000,000 bearing interest at prime plus 1% (5.0% at June 30, 2004)
    
    $
    5,111,111
    
    
    $
    Reducing revolving line of credit not to exceed $9,000,000 bearing interest at LIBOR plus 2.55%
(3.70% at June 30, 2004)
    
    
    8,128,953
    
    
    
    Convertible subordinated notes bearing interest at 15%. $9,000,000 converted into 1,753,604
shares of common stock upon the closing of the merger with Hycor (see Note 2)
    
    
    
    
    
    
    23,985,101Debt from bond indenture agreement with Bastrop County, Texas in the original principal amount
of $9,100,000, at an average interest rate of 1.19% and 1.33% for the three and six months
ended June 30, 2004, respectively (1.15% at June 30, 2004 and 1.65% at December 31, 2003)
    
    
    4,750,000
    
    
    
    5,620,000Phenogenex promissory note totaling $637,500 and bearing interest at 7.5%
    
    
    622,909
    
    
    
    630,074Vehicle financing totaling $156,486 and bearing interest at rates up to 4.5%
    
    
    128,934
    
    
    
    146,50418,741,907
    
    
    
    30,381,679Current portion of long-term debt
    
    
    3,587,033
    
    
    
    920,062Long-term debt, less current portion
    
    $
    15,154,874
    
    
    $
    29,461,617
 13




---



##### Table of Contents



The aggregate maturities of long-term debt principal payments for each of
the five years subsequent to June 30, 2004 are as follows: PrincipalPaymentLess than one year
    
    $
    3,587,033One year
    
    
    3,323,973Two years
    
    
    8,394,603Three years
    
    
    265,650Four years
    
    
    250,648Thereafter
    
    
    2,920,000Total
    
    $
    18,741,907
 7. Comprehensive Income Components of comprehensive income, net of income taxes, were as follows: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    1,459,277
    
    
    $
    1,132,197
    
    
    $
    3,533,189
    
    
    $
    2,406,872Foreign currency translation loss
    
    
    (302,978
    )
    
    
    (234,624
    )
    
    
    (1,283,934
    )
    
    
    (292,267
    )Unrealized gains on securities
    
    
    733
    
    
    
    
    
    
    
    733
    
    
    
    Comprehensive income, net of tax
    
    $
    1,157,032
    
    
    $
    897,573
    
    
    $
    2,249,988
    
    
    $
    2,114,605
 8. Employee Stock Purchase Plan In June 2004, the Company adopted the Stratagene Corporation Employee
Stock Purchase Plan (ESPP) that provides for the issuance of up to 1,000,000
shares of the Companys common stock. The ESPP is intended to qualify under
Section 423 of the Internal Revenue Code and is for the benefit of qualifying
employees as designated by the board of directors. Under the terms of the
ESPP, purchases are made quarterly. Participating employees may elect to have
a maximum of 15% of their compensation, up to a maximum of $21,250 per calendar
year, withheld through payroll deductions to purchase shares of common stock
under the ESPP. The purchase price of the common stock purchased under the
ESPP will be equal to 85% of the fair market value of the common stock on the
offering or grant date or the exercise or purchase date, whichever is lower.
The initial quarterly purchase period began on July 1, 2004. 9. Commitments and Contingencies Legal Stratagene is a party to litigation in the ordinary course of
business. Due to the uncertainties inherent in litigation, no assurances can be
given as to the outcome of these proceedings. If any of these matters were
resolved in a manner unfavorable to Stratagene, its business, financial
condition and results of operations could be materially harmed. Additionally,
favorable outcomes or gain contingencies that may result from these matters, if
any, are not recognized until they are realized. Information on the most
significant of these matters follows. Invitrogen Corporation In June 2000, Stratagene was sued by Invitrogen Corporation (formerly Life
Technologies, Inc.) in the United States District Court for the District of
Maryland. The complaint alleges that Stratagene willfully infringed United
States patent no. 6,063,608 (and United States patent nos. 5,244,797 and
5,405,776) for making, using and selling products derived from, using or
containing RNase H minus reverse transcriptase enzymes. Invitrogens motion for
a preliminary injunction was denied and the case was stayed pending a trial in
a related action involving Invitrogen and a third party regarding the same
patents. Invitrogen appealed the denial of an injunction and the stay to the
Federal Circuit Court of Appeals. In February 2002, the Federal Circuit Court
of Appeals affirmed the district courts decision. In September 2003,
Invitrogen filed a consent to judgment in the related action that the asserted
patents were invalid. Accordingly, the case against Stratagene remains
administratively stayed pending Invitrogens appeal. In addition, in March 2001, Stratagene was sued by Invitrogen in the
United States District Court for the Western District of Texas. Invitrogen
alleges (i) that Stratagene willfully infringed United States patent no.
4,981,797 for making, using and selling 14




---



##### Table of Contents



competent E. colicell products and (ii) damages of up to approximately
$22.0 million. In November 2001, the district court granted Stratagenes motion
for summary judgment, finding that the 797 patent was not infringed by
Stratagene. Invitrogen appealed the judgment to the Federal Circuit Court of
Appeals which, in May 2003, reversed the district courts decision in part and
remanded the case for further proceedings. In January 2004, in response to a
pending summary judgment motion, the district court ruled that Invitrogens
797 patent was invalid under 35 U.S.C. § 102(b). More specifically, the
district court found that Invitrogen had used the patented process claimed in
the 797 patent for commercial purposes for more than one year prior to the
filing date of the patent. Having found the 797 patent invalid, the district
court indicated there was no need for a trial. Invitrogen is currently
appealing the district courts ruling. In November 2001, Stratagene filed a complaint in the United States
District Court for the District of Maryland charging Invitrogen with willful
infringement and inducing others to infringe United States patent no. 5,556,772
for making, using, selling and offering for sale certain polymerase blend
products. Stratagene seeks a permanent injunction against continued
infringement as well as monetary damages (compensatory and enhanced) and
recovery of its attorneys fees and costs. Given the nature of patent
litigation, at the present time Stratagene is unable to quantify the amount of
remuneration it will ultimately seek in this proceeding or the likelihood of
recovering any portion of such remuneration once quantified. A trial is
currently scheduled to begin in March 2005. Invitrogen has filed requests for
re-examination of the 772 patent with the United States Patent and Trademark
Office. Takara Bio In November 2002, Stratagene filed a complaint in the United States
District Court for the District of Maryland charging Takara Bio with willful
infringement and inducing others to infringe United States patent no. 5,556,772
for making, using, selling and offering for sale certain polymerase blend
products. Stratagene seeks a permanent injunction, monetary damages
(compensatory and enhanced) and recovery of its attorneys fees and costs.
Given the nature of patent litigation, at the present time Stratagene is unable
to quantify the amount of remuneration it will ultimately seek in this
proceeding or the likelihood of recovering any portion of such remuneration
once quantified. Takara filed a counterclaim in a separate action in the United
States District Court for the Southern District of California. By its
counterclaim, Takara seeks joint ownership of Stratagenes 772 patent. In June
2003, Stratagene successfully moved to transfer the California action to
Maryland. In August 2003, the Maryland district court denied Takaras motion to
dismiss or transfer the complaint, and the cases have been consolidated for
pretrial and trial. No trial date has been set. The parties recently entered
into a joint stipulation to stay the proceedings to pursue settlement. Royalty Payments Accrued expenses and other liabilities in the June 30,
2004 balance sheet include $2.7 million of accrued royalties due to an
unrelated third party license holder for estimated royalties due from the
second quarter of 2003 through June 30, 2004. The Company has accrued royalties
under this patent license agreement based on an estimate of the
amounts in accordance with the patent license agreement. The
Companys calculations of royalty payments are subject to review
by the license holder. Beginning in the second half of 2003, such
royalty payments have been withheld by the Company while the Company
evaluates a possible overpayment of royalties paid in prior
periods. However, no assurances can be made that the Company will
recover any of the over payments. Employment Contracts Stratagene has entered into employment contracts
with certain of its officers. These contracts generally provide for severance
benefits if the officer is terminated by Stratagene other than for cause, as
defined in the employment contracts. See Note 2 for a summary of Dr. Sorges
new employment contract. Manufacturing move to Texas In June 2004, the Company made the decision
to move its manufacturing operations conducted in San Diego, California to its
primary manufacturing facility in Austin, Texas. As a result, the Company will
incur relocation and severance costs for employees affected by the transition.
In accordance with SFAS No. 146, Accounting for Costs Associated with Exit or
Disposal Activities, the Company has estimated the employee severance costs
associated with the move and will charge those costs to expense ratably over
the future service period. Management has estimated the costs to be
approximately $140,000, which will be recognized in the second half of 2004.
The estimated obligation is expected to be paid by the Company early in 2005. 10. New Accounting Pronouncements In March 2004, the FASB approved the consensus reached on the EITF Issue
No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments. EITF No. 03-1 provides guidance for identifying impaired
investments and new disclosure requirements for investments that are deemed to
be temporarily impaired. The accounting provisions of EITF 03-1 are effective
for all reporting periods beginning after June 15, 2004, while the disclosure
requirements are effective only for annual periods ending after June 15, 2004.
The Company does not believe the impact of adopting EITF No. 03-1 will be
significant to its overall results of operations or financial position. In May 2003, the FASB issued Statement No. 149, Amendments of Statement
No. 133 on Derivative Instruments and Hedging Activities(SFAS No. 149). This
statement amends and clarifies the financial accounting and reporting for
derivative instruments, 15




---



##### Table of Contents



including certain derivative instruments embedded in other contracts and
for hedging activities under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. The adoption of SFAS No. 149 did not have a
material effect on the Companys results of operations or financial position. In December 2003, the Securities and Exchange Commission released Staff
Accounting Bulletin (SAB) No. 104, Revenue Recognition,which supersedes SAB
No. 101, Revenue Recognition in Financial Statements.SAB No. 104 clarifies
existing guidance regarding revenues for contracts which contain multiple
deliverables to make it consistent with EITF No. 00-21, Accounting for Revenue
Arrangements with Multiple Deliverables.The adoption of SAB No. 104 did not
have a material impact on the Companys revenue recognition policies, nor its
financial position or results of operations. 11. Sale of Certain Assets in Joint Venture The Company has a 49% minority interest in a limited partnership (LP)
that operates a research lab. On June 1, 2004, prior to the BCH asset
acquisition by the Company (Note 2), the LP sold the assets related to its
clinical diagnostics business to a third party for approximately $4.5 million.
The consolidated financial statements reflect a $1.8 million gain in equity in
earnings of joint venture for BCHs share of the realized gain on the sale of
these assets. The taxes attributable to the gain are the responsibility of the
members of BCH and accordingly, the consolidated financial statements do not
include a provision for income taxes on this gain. The LP made a partial
distribution of the cash proceeds to BCH on June 1, 2004. In turn, BCH made a
distribution to its members to pay for the taxes related to the sale in the
amount of $476,280. The LP will distribute the remaining portion of BCHs net
proceeds once the accounting has been finalized for the transaction. Management
believes that there will be no further distributions to the BCH members, as the
distribution made on June 1, 2004 was for estimated taxes on the entire
transaction. 12. Segment Information The Company operates in two business segments: research supplies and
diagnostics. The segment information provided for the three and six months
ended June 30, 2004 includes only one month of diagnostic segment information,
as the Company only established a separate diagnostics reporting segment in
connection with the Hycor merger on June 2, 2004. Three Months Ended
    
    
    
    
    
    
    
    
    
    Three Months EndedResearch
    
    June 30, 2004
    
    
    
    
    
    Research
    
    June 30, 2003Supplies
    
    Diagnostics
    
    Total
    
    Supplies
    
    Diagnostics
    
    TotalProduct sales from external customers
    
    $
    17,653,540
    
    
    $
    2,092,989
    
    
    $
    19,746,529
    
    
    $
    17,025,245
    
    
    $
    
    
    
    $
    17,025,245Income before income taxes
    
    $
    829,677
    
    
    $
    616,160
    
    
    $
    1,445,837
    
    
    $
    1,665,337
    
    
    $
    
    
    
    $
    1,665,337
 Six Months Ended
    
    
    
    
    
    
    
    
    
    Six Months EndedResearch
    
    June 30, 2004
    
    Research
    
    Research
    
    June 30, 2003Supplies
    
    Diagnostics
    
    Supplies
    
    Supplies
    
    Diagnostics
    
    TotalProduct sales from external customers
    
    $
    37,075,562
    
    
    $
    2,092,989
    
    
    $
    39,168,551
    
    
    $
    33,900,903
    
    
    $
    
    
    
    $
    33,900,903Income before income taxes
    
    $
    3,910,884
    
    
    $
    616,160
    
    
    $
    4,527,044
    
    
    $
    3,609,660
    
    
    $
    
    
    
    $
    3,609,660
 At June 30, 2004 and December 31, 2003, total assets for each business
segment were as follows: Research
    
    June 30, 2004
    
    
    
    
    
    Research
    
    December 31, 2003Supplies
    
    Diagnostics
    
    Total
    
    Supplies
    
    Diagnostics
    
    TotalTotal assets
    
    $
    41,206,175
    
    
    $
    44,533,477
    
    
    $
    85,739,652
    
    
    $
    38,587,857
    
    
    $
    
    
    
    $
    38,587,857
 13. Restatement of Financial Statements As
previously disclosed in the Companys annual audited financial
statements included in
Amendment No. 3 to Form S-4 filed with the SEC on April 29, 2004, the Company identified
errors in its financial statements that related to its European subsidiary and
its derivative instruments. Certain amounts in the income statement for the
three and six months ended June 30, 2003 are different from amounts previously
reported. The following discussion provides an overview of the restatement and
related adjustments. Translation/Transaction Foreign Currency Adjustments 16




---



##### Table of Contents



The Company corrected the accounting of its European subsidiarys foreign
currency gains (losses) resulting from inventory purchased in US dollars, as
these were recorded as translation gains (losses) on the balance sheet rather
than as transaction gains (losses) in the income statement. As a result,
foreign currency transaction losses of $263,084 were reported in the income
statement for the three months ended June 30, 2003 and foreign currency
transaction gains of $25,743 were reported in the income statement for the six
months ended June 30, 2003. Derivative Instruments and Hedge Accounting The Company corrected the accounting for its foreign currency denominated
futures contracts, as the hedge accounting treatment did not comply with the
provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities. As a result, losses resulting from changes in the fair value of the
Companys derivative instruments of $167,075 and $227,281 for the three and six
months ended June 30, 2003, respectively, were reported in gain (loss) on
foreign currency transactions in the income statement. Also, for the three and six months ended June 30, 2003, the Company
reclassified $287,788 and $408,550, respectively, of realized foreign currency
losses associated with its futures contracts, from product sales to gain (loss)
on foreign currency transactions in the income statement. Other Items As a result of the restatement for the items discussed above, management
deemed it appropriate to record adjustments for certain other known items,
principally related to revenue recognition associated with product shipped that
had not reached its destination at period end, deferral and amortization of
revenue for extended service agreements and accruals for operating expenses. The following summarizes the effect of the restatement on the income
statement: Three months
    
    Six monthsended
    
    endedJune 30, 2003
    
    June 30, 2003Translation/transaction foreign currency adjustments
    
    $
    (263,084
    )
    
    $
    25,743Foreign currency futures contracts and hedge accounting
    
    
    (167,075
    )
    
    
    (227,281
    )Other items
    
    
    136,259
    
    
    
    (17,176
    )Pre-tax impact of adjustment to the income statement
    
    
    (293,900
    )
    
    
    (218,714
    )Tax benefit impact
    
    
    100,360
    
    
    
    76,212Total effect on net income
    
    $
    (193,540
    )
    
    $
    (142,502
    )
 The following table summarizes the effects of the restatement by financial
statement line item affected: Three months ended
    
    Six months endedJune 30, 2003
    
    June 30, 2003As Previously
    
    As
    
    As Previously
    
    AsReported
    
    Restated
    
    Reported
    
    RestatedIncome StatementFor the three and six months ended June 30, 2003:Product sales
    
    
    16,828,285
    
    
    
    17,025,245
    
    
    
    33,761,544
    
    
    
    33,900,903Cost of products sold
    
    
    5,439,675
    
    
    
    5,233,624
    
    
    
    10,754,825
    
    
    
    10,526,453General and administrative
    
    
    2,692,005
    
    
    
    2,701,494
    
    
    
    5,016,400
    
    
    
    5,027,352Gain (loss) on foreign currency transactions
    
    
    465,990
    
    
    
    (206,821
    )
    
    
    510,424
    
    
    
    (48,295
    )Income before income taxes
    
    
    1,959,237
    
    
    
    1,665,337
    
    
    
    3,828,374
    
    
    
    3,609,660Income tax expense
    
    
    (633,500
    )
    
    
    (533,140
    )
    
    
    (1,279,000
    )
    
    
    (1,202,788
    )Net income
    
    
    1,325,737
    
    
    
    1,132,197
    
    
    
    2,549,374
    
    
    
    2,406,872
 17




---



##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations The following information should be read in conjunction with the financial
statements and the related notes included in Item 1 of Part I of this Quarterly
Report onForm 10-Qand with the financial statements and related notes for the
year ended December 31, 2003 and the related Managements Discussion and
Analysis of Financial Condition and Results of Operations contained in
Amendment No. 3 to the Companys registration statement onForm S-4filed with
the Securities and Exchange Commission on April 29, 2004. The financial
information for Stratagene includes the accounts and balances of Stratagene
Corporation and subsidiaries on a consolidated basis. This Managements Discussion and Analysis of Financial Condition and
Results of Operations and other sections of this Quarterly Report on Form 10-Q
contain forward-looking statements and include assumptions concerning the
Companys operations, future results and prospects. These forward-looking
statements are based on current expectations and are subject to a number of
risks, uncertainties, and other factors. The Companys actual results could
differ materially from those expressed in or implied by these forward-looking
statements as a result of various factors, including those set forth below
under the caption Factors that May Affect Future Results. Overview Since inception in 1984, Stratagene has been engaged in developing,
manufacturing and marketing products used to conduct molecular biology
research. A substantial majority of its revenue comes from the sale of these
products. In 2003, approximately 38%, 50% and 4% of product sales were in the
areas of genetic technologies; nucleic acid and protein purification and
analysis; and genomics, proteomics, and bioinformatics, respectively.
Stratagenes research supplies products are used for research purposes and the
use of these products is not regulated by the U.S. Food and Drug Administration
(FDA) or by any comparable international organization. Stratagene manufactures its products for molecular biology research
customers in facilities near Austin, Texas and San Diego, California.
Stratagenes sales activities are primarily conducted through a dedicated
direct sales organization in North America and Europe. Approximately 11% of its
product sales in 2003 were to international distributors in selected countries
in Europe and Asia, who resell them to researchers. Certain products
manufactured by Stratagene in the United States are sold to Stratagenes
Netherlands branch for subsequent sale to their customers in Europe. Total
product sales outside the U.S. accounted for approximately 26% of total product
sales in 2003. In August 2003, Stratagene also opened a new facility in Japan
to establish direct sales and distribution channels in Asia. The Japan facility
recorded its first sale in the first quarter of 2004. As a result of the merger with Hycor Biomedical Inc. (see Merger with
Hycor below), Stratagene has expanded its product portfolio to include
diagnostics products with a focus on allergy and autoimmune testing and
urinalysis products. Hycor is registered as a manufacturer of medical devices
and a licensed biological manufacturer with the FDA. To comply with FDA
requirements, the Company must manufacture its diagnostics products in
conformance with the FDAs medical device Good Manufacturing Practice
regulations. Hycors existing products are also subject to certain pre-market
notification requirements of the FDA. Subsequent to the merger, Stratagene has determined that it operates in
two distinct operating segments; molecular biology research supplies and
medical diagnostic products. Stratagene markets its research supplies products to academic and
government institutions and pharmaceutical, biotechnology and industrial
companies. Historically, a substantial portion of product sales have been to
researchers at these academic and government institutions. Stratagene markets
its diagnostics products primarily to clinical laboratories and certain
specialty physicians. Merger with Hycor On June 2, 2004, Stratagene acquired all of the outstanding shares of
Hycor Biomedical Inc. through a merger of a wholly owned subsidiary of
Stratagene with Hycor, with Hycor continuing as a wholly owned subsidiary of
Stratagene. Pursuant to the merger agreement, Hycors stockholders received
0.6158 of a share of Stratagene common stock in exchange for each share of
Hycor common stock, plus cash for any fractional shares. The merger will be
recognized as a tax-free reorganization. Stratagene filed a registration
statement on Form S-4 (No. 333-109420) and related amendments in connection
with the transaction, which registration statement was declared effective by the Securities and
Exchange Commission on April 29, 2004. Stratagene has incurred merger-related
costs of approximately $1.7 million through June 30, 2004, which were
capitalized as a component of the purchase price. 18




---



##### Table of Contents



BCH Asset Acquisition Concurrently with the closing of the Hycor merger, Stratagene acquired
substantially all of the assets of BCH, including BCHs interests in its
subsidiaries. In exchange, Stratagene forgave all of the outstanding
intercompany indebtedness owed by BCH and its subsidiaries to Stratagene and
its subsidiaries of approximately $5.5 million and assumed all of the other
outstanding liabilities of BCH and its subsidiaries of approximately $0.8
million. Because Stratagene and BCH are under common control, and substantially
all of the BCH membership units are held by certain Stratagene shareholders,
the acquisition of BCH was recorded on a historical cost basis. As such, there
was no adjustment of BCHs assets and liabilities to fair value and no goodwill
resulting from the purchase. As of and for the periods ended June 30, 2004,
the financial statements are presented on a consolidated basis for Stratagene
Corporation, which represents a change in reporting entity under Accounting
Principles Board Opinion 20, Accounting Changes. Previously combined statements
are now presented on a consolidated basis as a result of the transaction. There
is no change to income for previous periods presented on a combined basis. For
tax purposes, this transaction is considered a taxable pooling. The financial
statements reflect net deferred tax assets of $750,000 for differences between
the tax and book basis of assets and liabilities acquired by
Stratagene. Prior to the acquisition date, Stratagene presented its financial
statements on a combined basis with BCH. BCH consisted substantially of
limited liability companies that were treated as partnerships for income tax
purposes; therefore, any related income tax liabilities were the responsibility
of the members. As a result, the operations of BCH did not reflect a provision
for income taxes in the combined financial statements. Beginning on June 2,
2004, the consolidated results of Stratagene, which includes the results of
BCH, includes a provision for income taxes. As part of the acquisition of BCH, Stratagene acquired BCHs interests in
its subsidiaries, which include Phenogenex, LLC (Phenogenex), Iobion
Informatics, LLC and subsidiaries (Iobion) and an investment in a joint
venture consisting of a 49% interest in a limited partnership that operates a
research lab. The investment is accounted for under the equity method. As a result of the acquisition, Stratagene owns 100% of Phenogenex and
approximately 78% of Iobion. The remaining 22% interest in Iobion is
represented by membership units held by two individuals. Gains, losses and cash
flows are allocated in accordance with the LLC agreement, generally first to
eliminate any deficit in a members capital account, next to provide for a
priority return to Stratagene, and then in accordance with respective ownership
percentages. For the six months ended June 30, 2004 and 2003, Iobion has
incurred losses of approximately $147,000 and $477,000, respectively. As of
June 30, 2004 and December 31, 2003, Iobion had accumulated deficits of
approximately $707,000 and $696,000, respectively. None of the losses have been
allocated to the minority holders of the 22% interest, due to the fact that
they did not fund initial capital contributions and have no requirement to make
future capital contributions to Iobion. Accordingly, Stratagene has absorbed
all losses incurred since inception. Basis of Presentation The financial information of the Company has been presented on a
consolidated basis, and includes the results of operations of Hycor Biomedical
Inc. and subsidiaries (Hycor) since Hycor was acquired by the Company on June
2, 2004. The financial information also includes the results of operations of
BioCrest Holdings, LLC (BCH), whose assets were acquired by the Company on
June 2, 2004 and accordingly is presented on a consolidated basis for all
periods (See Note 2 to financial statements). Critical Accounting Policies and Estimates The Companys consolidated financial statements are prepared in accordance
with accounting principles generally accepted in the United States of America
and management is required to make certain estimates, judgments and assumptions
that affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during
the periods presented. The significant accounting policies that the Company
believes are the most critical to aid in fully understanding and evaluating its
reported financial results include the following: Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the consolidated
financial statements and disclosures made in the accompanying notes. Actual
results could differ from those estimates. Revenue Recognition Revenue from biological products and basic instrumentation products is
recognized under the provisions of SAB No. 104, which is 19




---



##### Table of Contents



generally when products are shipped, title has transferred and risk of
loss has passed. In accordance with Statement of Position No. 97-2, Software
Revenue Recognition, as amended by Statement of Position No. 98-9, for
instrumentation products where software is a key component, revenue is
recognized when persuasive evidence of an arrangement exists, delivery has
occurred, the sales price is fixed or determinable and collectibility is
probable. Generally, these criteria are met at the time product is shipped and
title has transferred. When contractual acceptance clauses exist, revenue is
recognized upon satisfaction of such clauses. Contract research service
revenues are earned and recognized in accordance with contract provisions.
Government grant revenues related to research activities are recognized when
earned, generally as related research activities occur. Amounts received in
advance of performance or acceptance are recorded as deferred revenue. Accounts Receivable Stratagene performs ongoing credit evaluations of its customers and
adjusts credit limits based upon payment history and the customers current
creditworthiness. Stratagene continuously monitors collections and payments
from customers and maintains a provision for estimated credit losses based upon
historical experience and any specific customer collection issues that have
been identified. Stratagenes credit losses have historically been within
expectations and the provisions established. Inventories Inventories are valued at the lower of the actual cost to purchase and/or
manufacture the inventory or the current estimated market value of the
inventory. Stratagene regularly reviews inventory quantities on hand and
records a provision for excess and obsolete inventory on specifically
identified items based primarily on an estimated forecast of product demand and
production requirements. Stratagenes losses from disposal of excess or
obsolete inventory have historically been within expectations and the
provisions established. However, Stratagenes estimates of future product
demand may prove to be inaccurate, in which case Stratagene may have
understated or overstated the provision required for excess and obsolete
inventory. In addition, rapid technological change or new product development
could result in an increase in the quantity of obsolete inventory on hand. In
the future, if Stratagenes inventory is determined to be overvalued, it would
be required to recognize such costs in its cost of goods sold at the time of
such determination. Likewise, if Stratagenes inventory is determined to be
undervalued, it may have over-reported its costs of goods sold in previous
periods and would be required to recognize such additional operating income at
the time of sale. Additionally, Stratagenes manufacturing costs and inventory carrying
costs are dependent on managements accurate estimates of customer demand for
Stratagenes products. A significant increase in the demand for Stratagenes
products could result in a short-term increase in the cost of inventory
purchases, while a significant decrease in demand could result in an increase
in the amount of excess inventory quantities on hand and increase the expense
of storing and maintaining the inventory until it is sold. As a result,
although management attempts to maximize the accuracy of its forecasts of
future product demand, any significant unanticipated changes in demand or
technological developments could have a significant impact on the value of
Stratagenes inventory and its reported operating results. Deferred Taxes Stratagenes deferred tax assets relate primarily to prior operating
losses that are available to offset future taxable income and tax credits that
are available to offset future income taxes. Deferred taxes are also recognized
for differences between the financial statement carrying amounts and the tax
basis of assets and liabilities. Stratagene evaluates a variety of factors in
determining the amount of deferred income assets to be recognized pursuant to
SFAS No. 109, Accounting for Income Taxes. Long-lived Assets In 2002, Stratagene adopted SFAS No. 142, Goodwill and Intangible Assets,
which requires that long-lived assets be reviewed for impairment at least
annually. With the acquisition of Hycor in the second quarter of 2004,
Stratagene has substantial amortizable and non-amortizable long-lived assets
(including goodwill) that are reviewed for impairment at each calendar year end
and when there is an indication that the carrying value of an asset may not be
recoverable. An impairment loss will be recognized if the carrying amount
exceeds the fair value of the asset. Royalties Stratagene enters into license agreements in the ordinary course of its
business, which require royalty payments based on specified product sales.
These agreements cover the majority of Stratagenes products. Since mid-2003,
Stratagene has withheld payments to a license holder while Stratagene evaluates
a possible overpayment in the royalties paid in prior periods. Stratagene has
continued to record the estimated quarterly royalty payable under the patent
license agreement and reports this amount to the license holder. Management
believes the royalty payments accrued are determined in accordance
with the patent license agreement. However, the Companys
calculations of royalty payments are subject to review by the license
holder. Therefore, Stratagenes 20




---



##### Table of Contents



financial position or results of operations could be materially affected
if the parties later determine that the royalty calculation differs
significantly from the amounts recorded by Stratagene. As of June 30, 2004, the
amount of accrued and unpaid royalties related to this patent license agreement
was $2.7 million. Warranties Stratagene warrants certain equipment against defects in workmanship or
materials for a period of one year from the date of purchase. Upon recognition
of the sale of equipment sold that includes a warranty, Stratagene establishes,
as part of cost of goods sold, a provision for the expected costs of such
warranty. While Stratagenes warranty costs have historically not been
significant, Stratagene cannot guarantee that it will continue to experience
the same warranty return rates that it has in the past. A significant increase
in product return rates could have a material adverse impact on operating
results for the period or periods in which such returns materialize. Derivative Financial Instruments Stratagene accounts for derivative financial instruments in accordance
with SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, as amended, and related literature, which we refer to collectively
as SFAS No. 133. Stratagene enters into derivative instruments to reduce the
risk of foreign currency fluctuations; however, such derivative instruments do
not qualify for hedge accounting under the provisions of SFAS No. 133.
Accordingly, both unrealized and realized gains or losses resulting from
changes in fair value are recognized as incurred in gain (loss) on foreign
currency transactions in the current period income statement. Research and Development Stratagene focuses its research and development efforts on developing
products that use innovative technologies in both the research supplies and
diagnostics product lines. For the six months ended June 30, 2004 and for
fiscal year 2003, Stratagene spent an aggregate of approximately $5.3 million
and $10.5 million, respectively, in the areas of genetic technologies; nucleic
acid and protein purification and analysis; genomics, proteomics and
bioinformatics; and medical diagnostics. Stratagenes numerous research and development initiatives are generally
ongoing. Some of the efforts are for new product technologies, while others are
designed to support an existing product or products relating to one of
Stratagenes more than 2,500 stock keeping units, which are represented in
approximately 75 existing product categories. In addition, the funds used by
Stratagene in its research and development activities are allocated among the
various technologies and products in which Stratagene is currently involved and
are not concentrated to one specific product or product line. Since 1997,
Stratagene has spent over $67 million on its research and development efforts
and intends to spend between 12% and 14% of its revenues on research and
development activities for at least the next few years. Stratagene does not provide forward-looking estimates of costs and time to
complete any of its individual ongoing research and development projects
because none of such projects are material to the company on an individual
basis. In addition, any such estimates would be subject to a number of risks
and uncertainties, including Stratagenes ability to predict the outcome of
complex research, competition from other entities of which Stratagene may
become aware in future periods, predictions of market potential from products
that may be derived from Stratagenes research and development efforts and
Stratagenes ability to recruit and retain personnel with the necessary
knowledge and skills to perform the required research activities. Results of Operations Three months ended June 30, 2004 compared to three months ended June 30,
2003 Product Sales For the three months ended June 30, 2004, revenue increased $2.7 million
or 16.0% compared to the three months ended June 30, 2003. This increase was
primarily attributable to the Company recording one month of Hycors
diagnostics product sales of $2.1 million as a result of the merger on June 2,
2004, which constitutes approximately 12.3% of the increase for the three
months ended June 30, 2004. Also contributing to the growth was increased
sales of research supplies products by Stratagene of $0.6 million, or 3.7% for
the three months ended June 30, 2004 when compared to the same period in 2003.
Sales during the three months ended June 30, 2004 were also affected by the
weakening dollar resulting in a positive foreign exchange impact to foreign
sales of 5.8% and a 1.5% increase to total worldwide revenue for the three
months ended June 30, 2004 when compared to the three months ended June 30,
2003. Stratagene expects that future revenue will depend on a number of
factors, including the market acceptance of new products, competitive
conditions, currency fluctuations and the continued funding of customer
research budgets. 21




---



##### Table of Contents



Gross Profit Gross profit as a percentage of sales decreased 5.4% from 69.3% for the
three months ended June 30, 2003 to 63.9% for the three months ended June 30,
2004 due to increased manufacturing variances and the impact of lower margin
diagnostic products sales. Research and Development Expenses Research and development expenses increased $0.1 million or 2.1% for the
three months ended June 30, 2004 compared to the same period in 2003. As a
percentage of product sales, research and development expenses decreased from
16.2% for the three months ended June 30, 2003 to 14.2% for the three months
ended June 30, 2004. The increase in spending was primarily due to
approximately $250,000 of non-cash stock-based compensation expense for stock
options granted to non-employee advisors of Stratagene. Selling and Marketing Expenses Selling and marketing expenses increased $0.7 million or 19.1% for the
three months ended June 30, 2004 compared to the same period in 2003. The
increase in spending was due to the Company recording one month of Hycor sales
and marketing expenses of approximately $0.3 million and approximately $0.4
million of expenses related to increased marketing communication activity and
increased costs related to Stratagenes Japanese operations, which commenced in
the second quarter of 2003. As a percentage of total revenue, selling and
marketing expenses increased slightly from 21.1% for the three months ended
June 30, 2003 to 21.6% for the three months ended June 30, 2004. As a result of
the merger with Hycor, Stratagene recorded amortizable intangible assets
related to trade names and customer contracts. These intangible assets are
being amortized to sales and marketing expense over one to five years beginning
in June of 2004. The monthly amortization expense is approximately $33,000.
See Note 2 to the Companys consolidated financial statements for the period
ended June 30, 2004. General and Administrative Expenses General and administrative expenses increased by $2.8 million or 102.5%
for the three months ended June 30, 2004 compared to the same period in 2003.
As a percentage of total revenue, general and administrative expenses increased
from 15.9% for the three months ended June 30, 2003 to 27.7% for the three
months ended June 30, 2004. The increased spending is primarily due to charges
of $2.4 million related to bonuses Dr. Sorge received as a result of the merger
with Hycor and one month of Hycors general and administrative expenses of $0.2
million. Impairment of Long-Lived Assets Impairment of long-lived assets was approximately $7,000 for the three
months ended June 30, 2004. There was no impairment charge for the three
months ended June 30, 2003. This expense relates to writing-off the remaining
unamortized balances of patents that management believes are not recoverable. Total Other Income (Expense), Net Total other income (expense), net increased in income by $2.5 million or
227.3% for the three months ended June 30, 2004 compared to the same period in
2003. As a result of the BCH asset acquisition, Stratagene has a 49% minority
interest in a limited partnership (LP) that operates a research lab. On June
1, 2004, prior to the BCH asset acquisition by the Company, the LP sold the
assets related to its clinical diagnostics business to a third party for
approximately $4.5 million. The consolidated financial statements for the three
months ended June 30, 2004 reflect a $1.8 million gain in equity in earnings of
joint venture for the Companys share of the realized gain on the sale of those
assets. Also contributing to the net increase was a reduction in interest expense
of $0.4 million for the three months ended June 30, 2004 resulting from the
refinancing of the Companys debt obligations in the first quarter of 2004,
which reduced the weighted average interest rate on outstanding borrowings from
10% to approximately 7.5%. In addition, $9.0 million of convertible
subordinated notes were converted into shares of Stratagene common stock in
connection with the closing of the Hycor merger. The weighted average interest
rate on the remaining debt facilities is approximately 3.5% for the second half
of 2004. Income Taxes Stratagene recorded a $13,000 tax benefit for the three months ended June
30, 2004 as a result of taxable income decreasing in the three months ended
June 30, 2004. Prior to the acquisition date, Stratagene and BCH presented
their financial statements on a 22




---



##### Table of Contents



combined basis as a result of being under common control and because
substantially all the BCH membership units were held by certain Stratagene
shareholders. BCH consisted substantially of limited liability companies that
were treated as partnerships for income tax purposes; therefore, any related
income tax liabilities were the responsibility of the members. As a result, the
operations of BCH did not reflect a provision for income taxes in the combined
financial statements. Beginning on June 2, 2004, the consolidated results of
Stratagene, which includes the results of BCH, includes a provision for income
taxes. As discussed above, on June 1, 2004, prior to the BCH asset acquisition
by the Company, BCH recorded a gain in equity in earnings of joint venture of
$1.8 million related to the sale of certain of the LPs assets. The income
taxes attributable to the gain are the responsibility of the members of BCH and
accordingly, the consolidated financial statements do not include a provision
for income taxes on this gain. Stratagene recognizes state research and development and other credits
when they are generated. Excess credits are recognized and will be used to
offset future taxable income as management believes it is more likely than not
that the credits will be realized. Six months ended June 30, 2004 compared to six months ended June 30, 2003 Product Sales For the six months ended June 30, 2004, revenue increased $5.3 million or
15.5% as compared to the six months ended June 30, 2003. This growth was partly
attributable to the merger with Hycor, which contributed $2.1 million of
diagnostics product sales, or 6.2% of the increase in sales for the six months
ended June 30, 2004 over the comparable period in 2003. Also contributing to
the growth was increased sales of the research supplies product line of $3.2
million, or 9.4% for the six months ended June 30, 2004 when compared to the
same period in 2003. Sales during the six months ended June 30, 2004 were also
affected by the weakening dollar resulting in a positive foreign exchange
impact to foreign sales of 10.8% and a 2.6% increase to total worldwide revenue
for the six months ended June 30, 2004 when compared to the six months ended
June 30, 2003. For the six months ended June 30, 2004, approximately 2.7% of
the growth was attributable to the shipment of backordered products ordered in
2003. Gross Profit Gross profit as a percentage of sales decreased 2.2% from 68.9% for the
six months ended June 30, 2003 to 66.7% for the six months ended June 30, 2004
due to increased manufacturing variances and the impact of lower margin
diagnostic products sales. Research and Development Expenses Research and development expenses decreased $0.3 million or 4.7% for the
six months ended June 30, 2004 compared to the same period in 2003. As a
percentage of product sales, research and development expenses decreased from
16.5% for the six months ended June 30, 2003 to 13.6% for the six months ended
June 30, 2004. The decrease was primarily due to transitioning the Mx3000P
instrument from research and development to manufacturing in the third quarter
of 2003, offset by approximately $255,000 of stock-based compensation expense
for stock options granted to non-employee advisors of Stratagene. Selling and Marketing Expense Selling and marketing expenses increased $0.8 million or 9.9% for the six
months ended June 30, 2004 compared to the same period in 2003. The increase in
spending was due to the Company recording one month of Hycors sales and
marketing expenses of approximately $0.3 million and approximately $0.5 million
of expenses related to increased marketing communication activity and increased
costs related to Stratagenes Japanese operations, which commenced in the
second quarter of 2003. As a percentage of total revenue, selling and
marketing expenses decreased 1.0% from 22.3% for the six months ended June 30,
2003 to 21.3% for the six months ended June 30, 2004. General and Administrative Expenses General
and administrative expenses increased by $3.5 million or 70.3% for
the six months ended June 30, 2004 compared to the same period in 2003. As a
percentage of total revenue, general and administrative expenses increased from
14.8% for the six months ended June 30, 2003 to 21.9% for the six months ended
June 30, 2004. The increased spending was primarily due to charges of $2.4
million related to bonuses Dr. Sorge received as a result of the merger with
Hycor, one month of Hycors general and administrative expenses of $0.2 million
and $0.9 million of expenses related to increased legal fees associated with
patent litigation and debt refinancing, as well as increased investment in the
Japanese operations. Impairment of Long-Lived Assets 23




---



##### Table of Contents



Impairment of long-lived assets was approximately $58,000 for the six
months ended June 30, 2004. There were no impairment charges for the six
months ended June 30, 2003. This expense relates to writing-off the remaining
unamortized balances of patents that management believes are not recoverable. Total Other Income (Expense), Net Total other income (expense), net increased in income by $2.3 million or
143.6% for the six months ended June 30, 2004 compared to the same period in
2003. As a result of the BCH asset acquisition, Stratagene has a 49% minority
interest in a limited partnership that operates a research lab. On June 1,
2004, prior to the BCH asset acquisition by the Company, the LP sold the assets
related to its clinical diagnostics business to a third party for approximately
$4.5 million. The consolidated financial statements for the six months ended
June 30, 2004 reflect a $1.8 million gain in equity in earnings of joint
venture for the Companys share of the realized gain on the sale of these
assets. Also contributing to the net increase was a reduction in interest expense
of $0.4 million for the six months ended June 30, 2004 resulting from the debt
refinancing, which reduced the weighted average interest rate on outstanding
borrowings from over 10% to approximately 7.5%. In addition, $9.0 million of
convertible subordinated notes were converted into shares of Stratagene common
stock in connection with the closing of the Hycor merger. The weighted average
interest rate on the remaining debt facilities is approximately 3.5%. Income Taxes Stratagene recorded $1.0 million of tax expense for the six months ended
June 30, 2004. The effective tax rate increased from 33.3% for the six months
ended June 30, 2003 to 36.0% for the same period in 2004. The change in the
effective tax rate was primarily a result of the BCH asset acquisition and
related transactions. Prior to the BCH asset acquisition date, Stratagene and
BCH presented their financial statements on a combined basis as a result of
being under common control and because substantially all the BCH membership
units were held by certain Stratagene shareholders. BCH consisted
substantially of limited liability companies that were treated as partnerships
for income tax purposes; therefore, any related income tax liabilities were the
responsibility of the members. As a result, the operations of BCH did not
reflect a provision for income taxes prior to the acquisition date. As
discussed above, on June 1, 2004, prior to the BCH asset acquisition by the
Company, BCH recorded a gain in equity in earnings of joint venture of $1.8
million related to the sale of certain of the LPs assets. The income taxes
attributable to the gain are the responsibility of the members of BCH and
accordingly, the consolidated financial statements do not include a provision
for income taxes on this gain. Stratagene recognizes state research and development and other credits
when they are generated. Excess credits are recognized and will be used to
offset future taxable income as management believes it is more likely than not
that the credits will be realized. Liquidity and Capital Resources Stratagenes liquidity requirements have historically consisted of
research and development expenses, sales and marketing expenses, debt service,
capital expenditures, working capital and general corporate purposes. These
expenses have been funded primarily through cash from operations, supplemented
with borrowings under credit facilities and other debt instruments. Stratagene generated net cash from operating activities of $4.4 million
and $4.1 million for the six months ended June 30, 2004 and 2003, respectively. For the six months ended June 30, 2004, Stratagene generated net cash from
investing activities of $4.9 million and used $0.6 million of net cash in its
investing activities for the six months ended June 30 2003. Cash acquired
related to the merger with Hycor, net of acquisition costs of $1.8 million,
totaled $4.5 million for the six months ended June 30, 2004. Cash
distributions from a joint venture resulting from the sale of certain assets of
the joint venture totaled $1.0 million and $0 for the six months ended June 30,
2004 and 2003, respectively. Capital expenditures and additions to patents for
the six months ended June 30, 2004 totaled $0.4 million and $0.7 million,
respectively, as compared to $0.6 million and $0.5 million for the six months
ended June 30, 2003, respectively. Stratagene
used $3.8 million and $1.6 million in net cash for financing
activities for the six months ended June 30, 2004 and 2003, respectively, which
included the repayment of $17.3 million and $2.5 million in debt offset by
borrowings under the Companys credit facilities of $14.1 million and $1.1
million, respectively. Based on managements review of Stratagenes accounts receivables, an
allowance for doubtful accounts is accrued, however, Stratagene does not write
off individual accounts receivable until substantially all avenues of legal
recourse to collect the outstanding amount have been exhausted. The actual
write-off for the six months ended June 30, 2004 was minimal and the allowance
decreased 24




---



##### Table of Contents



by approximately $0.2 million. This decrease in expected uncollectible
accounts was due in part to continued collection efforts. No significant change
to future liquidity is anticipated. Gross
accounts receivable provided cash of $0.4 million for the six months ended
June 30, 2004 due primarily to collection efforts. Days sales outstanding
decreased from 39 days at December 31, 2003 to 37 days at June 30, 2004. For
the six months ended June 30, 2003, accounts receivable used cash of $1.3
million primarily due to strong sales in the first quarter of 2003. Due to related party was a source of cash of $1.4 million for the six
months ended June 30, 2004 due to a bonus awarded to Dr. Sorge in connection
with the merger with Hycor, which is being paid over 39 months, offset by
payment of deferred compensation to an officer of $0.3 million. Accrued expenses and other liabilities was a use of cash of $1.2 million
for the six months ended June 30, 2004 due to the Companys payment of Hycor
merger related expenses subsequent to the merger date, offset by increased
royalty and employee compensation accruals. For the six months ended June 30,
2003, accrued expenses and other liabilities provided a source of cash of $0.1
million. Capital expenditures for property and equipment during the six
months ended June 30, 2004 and 2003 were approximately $0.4 million and $0.6
million, respectively. For fiscal 2004, Stratagene currently anticipates
capital spending on property and equipment to be in the range of $1.0 million
to $1.5 million. Stratagene had cash, cash equivalents and restricted cash totaling $8.7
million and $2.7 million at June 30, 2004 and December 31, 2003, respectively,
and working capital of $17.4 million and $9.5 million at June 30, 2004 and
December 31, 2003, respectively. As of June 30, 2004, Stratagene had approximately $18.7 million in total
debt. This debt included approximately $5.1 million in senior term debt, $8.1
million under Stratagenes reducing revolving line of credit and $4.8 million
in industrial revenue bonds issued by BioCrest Manufacturing, L.P., a
subsidiary of Stratagene. On January 21, 2004, Stratagene, BioCrest Manufacturing and BioCrest
Holdings, LLC entered into a senior credit agreement and related documents with
Merrill Lynch Business Financial Services Inc., which is referred to in this
Form 10-Q as MLBFS, pursuant to which MLBFS made various credit facilities
available to BioCrest Manufacturing. The senior credit facility consists of (1)
a $4.0 million one-year revolving borrowing base facility, (2) a $9.0 million
three-year reducing revolving facility, (3) a $6.0 million 27-month term loan
and (4) a one-year letter of credit facility to support the industrial revenue
bonds issued by BioCrest Manufacturing. On January 23, 2004, Stratagene
borrowed approximately $14.1 million of the aggregate availability under the
reducing revolving facility and the term loan, of which $14.0 million was used
to pay down the principal amount of the subordinated notes and the remaining
amount was used to pay various MLBFS and other third party fees. Stratagene
paid all amounts due and owing under the non-convertible subordinated notes in
March and April 2004 and the convertible subordinated notes were converted into
an aggregate of 1,753,604 shares of Stratagene common stock upon the closing of
the merger transaction with Hycor. As a result, all of the Companys
obligations under the subordinated notes have been satisfied and there are no
subordinated notes currently outstanding. The obligations of BioCrest Manufacturing under the senior credit facility
have been guaranteed by each of Stratagene and BioCrest Holdings and each of
their wholly owned domestic subsidiaries. The obligations are also generally
secured by substantially all of the personal property assets of Stratagene and
BioCrest Holdings and each of their wholly owned domestic subsidiaries, as well
as liens on the real property and improvements related to Stratagenes Texas
manufacturing facility. The senior credit facility is also secured by a pledge
of Stratagenes 78% interest in Iobion Informatics. In addition, Stratagenes
CEO personally guaranteed the obligations of BioCrest Manufacturing under the
senior credit facility. This personal guarantee terminated in connection with
the closing of the merger with Hycor. Borrowings under the senior credit facility bear interest (1) in the case
of the one-year revolving facility, at a variable rate equal to the one-month
LIBOR rate plus 2.40%, (2) in the case of the three-year reducing revolving
facility, at a variable rate equal to the one-month LIBOR rate plus 2.55%, and
(3) in the case of the term loan, at a variable rate equal to the prime rate
plus 1.00%. The senior credit facility includes customary but significant
restrictions on the incurrence of additional debt, the payment of dividends,
acquisitions and capital expenditures above stated limits. The senior credit
facility also contains restrictive covenants requiring the Company to maintain
certain financial ratios, including minimum debt service coverage ratios, fixed
charge coverage ratios and tangible net worth. The Company was in compliance
with all covenants as of June 30, 2004. The industrial revenue bonds issued by BioCrest Manufacturing are secured
by land, building and equipment acquired in Bastrop County, Texas with the
proceeds from the issuance of the bonds. The average interest rate on the
industrial revenue bonds for the six months ended June 30, 2004 was 1.33% and
1.68% for fiscal 2003. Under the instrument governing the industrial revenue
bonds, Stratagene was required to make sinking fund payments of $870,000 per
year through April 2004, and is required to make sinking 25




---



##### Table of Contents



fund payments of $735,000 through April 2005, $240,000 per year through
April 2021, and then $175,000 through April 2022 when the bonds mature. Stratagene leases certain facilities and equipment under noncancelable
operating leases, with equipment leases expiring from August 2006 through
January 2007 and facility leases expiring in December 2007 and September 2008
for its domestic facilities and from December 2004 through December 2007 for
its foreign facilities. In addition, in the normal course of operations, Stratagene enters into
purchase obligations with various vendors and suppliers of various key raw
materials and other goods and services through purchase orders or other
documentation. Such obligations are generally outstanding for periods of less
than one year and are settled by cash payments upon delivery of goods and
services. At June 30, 2004, the purchase commitments covered by these various
key raw materials and other goods and services aggregate approximately
$3,325,000. The following table summarizes the approximate future minimum payments
under the above contractual obligations at June 30, 2004: Payment Due by PeriodLess than
    
    1-3
    
    4-5
    
    After 5Contractual Obligations
    
    Total
    
    1 Year
    
    Years
    
    Years
    
    YearsOperating leases
    
    $
    7,173,652
    
    
    $
    1,983,357
    
    
    $
    4,651,646
    
    
    $
    538,649
    
    
    
    Long-term debt
    
    
    18,741,908
    
    
    
    3,587,033
    
    
    
    11,984,227
    
    
    
    490,648
    
    
    
    2,680,000Note payable to related party
    
    
    1,780,000
    
    
    
    547,692
    
    
    
    1,232,308
    
    
    
    
    
    
    
    Other purchase commitments
    
    
    3,325,000
    
    
    
    3,325,000
    
    
    
    
    
    
    
    
    
    
    
    Total contractual obligations
    
    $
    31,020,560
    
    
    $
    9,443,082
    
    
    $
    17,868,181
    
    
    $
    1,029,297
    
    
    $
    2,680,000
 Other Commitments and Contingencies In connection with the closing of the Hycor merger, Stratagene entered
into a new employment agreement with Dr. Sorge, pursuant to which, among other
things, Dr. Sorges base annual salary was reduced from $1.1 million to
$450,000, and Dr. Sorge was granted an option to purchase 738,960 shares of
Stratagene common stock at an exercise price of $9.34 per share. The agreement
provides for Dr. Sorges base salary to be reviewed on at least an annual basis
by the compensation committee of the board of directors, which may also
increase Dr. Sorges base salary from time to time in its discretion. It is
anticipated that if the Company establishes any general bonus program for
senior executives based upon the attainment of established goals, Dr. Sorge
shall be entitled to participate in such program on a basis at least comparable
to other senior executives. Dr. Sorge may also receive bonuses at the
discretion of the board of directors upon the recommendation of the
compensation committee. The new employment agreement has an initial term of
three years and is subject to successive one year renewals unless either party
provides a notice of non-renewal at least 30 days prior to the termination of
the then current term. New Accounting Pronouncements Information regarding recent accounting pronouncements is contained in
Note 10 to the Consolidated Financial Statements for the period ended June 30,
2004, which note is incorporated herein by this reference and is included as
part of Item 1. Financial Statements, to this Form 10-Q. Cautionary Note Regarding Forward-Looking Statements Some of the statements in this Quarterly Report on Form 10-Q, including,
but not limited to, this Managements Discussion and Analysis of Financial
Condition and Results of Operations, are forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. These statements are
therefore entitled to the protection of the safe harbor provisions of these
laws. Stratagene generally identifies forward-looking statements in this
Quarterly Report by using words like believe, intend, target, expect,
estimate, may, should, plan, project, contemplate, anticipate,
predict or similar expressions. You can also identify forward-looking
statements by discussions of strategies, plans or intentions. These statements
involve known and unknown risks, uncertainties and other factors that may cause
the Companys actual results, levels of activity, performance or achievements
to be materially different from any future results, levels of activity,
performance or achievements expressed or implied by these forward-looking
statements. These factors include the absence of a public market for the
Stratagene common stock prior to the Hycor merger, the challenges of
integrating Stratagene and Hycor, Stratagenes ability to introduce new
products and the acceptance of these products by the marketplace, competition,
the inability to sell products as a result of the termination of license
agreements, fluctuations in operating results, dependence on key employees,
Stratagenes substantial indebtedness, future capital requirements, the
possibility of unproductive 26




---



##### Table of Contents



research and development projects, ability to manage growth, price
volatility of Stratagenes common stock, the impact of future sales of common
stock on Stratagenes stock price and potential declines in research and
development budgets or funding. For more information about the risks faced by
the Company, please see Risk Factors included in the Companys Form S-4
Registration Statement relating to the merger transaction with Hycor and the
discussion set forth below under the caption Factors that May Affect Future
Results. Although Stratagene believes that the expectations reflected in its
forward-looking statements are reasonable, Stratagene cannot guarantee future
results, events, levels of activity, performance or achievement. Stratagene
undertakes no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise,
unless required by law. Factors that May Affect Future Results It is important to carefully consider the following risks, together with
other matters described in this Form 10-Q or in other documents referred to in
this Form 10-Q in evaluating Stratagenes business and prospects. If any of
the following risks occur, Stratagenes business, financial condition or
operating results could be harmed. In such case, the trading price of
Stratagenes securities could decline. The risks described below are not the
only risks Stratagene faces. Additional risks not presently known to
Stratagene or that Stratagene currently deem immaterial may also impair
business operations. For a further discussion of factors that could affect
future results or performance, please see Risk Factors included in the
Companys Form S-4 Registration Statement relating to the merger transaction
with Hycor. Stratagenes future success depends on the timely introduction of new
products and the acceptance of these new products in the marketplace. Rapid technological change and frequent new product introductions are
typical for the markets Stratagene serves. Stratagenes future success will
depend in large part on continuous, timely development and introduction of new
products that address evolving market requirements. Stratagene believes successful new product introductions provide a
significant competitive advantage because customers make an investment of time
in selecting and learning to use a new product, and are reluctant to switch
thereafter. To the extent that Stratagene fails to introduce new and innovative
products, it may lose market share to its competitors, which may be difficult
to regain. Any inability, for technological or other reasons, to successfully
develop and introduce new products could materially damage Stratagenes
business. In the past Stratagene has experienced, and is likely to experience in the
future, delays in the development and introduction of products. Stratagene
cannot assure you that it will keep pace with the rapid rate of change in life
sciences research, or that its new products will adequately meet the
requirements of the marketplace or achieve market acceptance. Some of the
factors affecting market acceptance of new products include:  
    
    availability, quality and price relative to competitive products;
    
    the timing of introduction of the product relative to competitive products;
    
    customers opinions of the products utility;
    
    citation of the product in published research; and
    
    general trends in life sciences research. The markets for Stratagenes products are extremely competitive and
subject to rapid technological change and if Stratagene fails to compete
effectively, its business may suffer. The markets for Stratagenes products are highly competitive. Stratagene
competes with many other suppliers of life sciences research products and
diagnostics products. Stratagenes major competitors in the genetic
technologies market area include Invitrogen Corporation, BD Biosciences,
Promega and Novagen. Stratagenes major competitors in the nucleic acid and
protein purification and analysis market area include Applied Biosystems,
Qiagen, Roche and Invitrogen. Stratagenes major competitors in the genomics,
proteomics and bioinformatics market area include Invitrogen, Applied
Biosystems, Agilent and Silicon Genetics. Stratagenes major competitors in the
diagnostics product area include Pharmacia, Inc. and Diagnostic Product
Corporation. Many of Stratagenes competitors have greater financial,
operational and sales and marketing resources and more experience in research
and development 27




---



##### Table of Contents



than it does. These and other companies may have developed or could in the
future develop new technologies that compete with Stratagenes products or even
render Stratagenes products obsolete. Competition in Stratagenes markets is
primarily driven by:  
    
    product performance, features and reliability;
    
    price;
    
    timing of product introductions;
    
    ability to develop, maintain and protect proprietary products and technologies;
    
    sales and distribution capabilities;
    
    technical support and service; and
    
    breadth of product line. If a competitor develops or acquires superior technology or cost-effective
alternatives to Stratagenes products, Stratagenes business, financial
condition and results of operations could be materially adversely affected. Stratagenes competitors have in the past and may in the future compete by
lowering prices. Stratagene may respond by lowering its prices, which could
reduce revenues and profits. Conversely, failure to anticipate and respond to
price competition may damage Stratagenes market share. In addition, Stratagene
must continually adapt to new marketing and distribution trends in order to
compete effectively. Stratagene believes that customers in its markets display a significant
amount of loyalty to their initial supplier of a particular product. Therefore,
it may be difficult to make sales to customers who have previously purchased
products from Stratagenes competitors. To the extent Stratagene is unable to
be the first to develop and supply new products, its competitive position may
suffer. If Stratagenes existing license agreements are terminated, Stratagene may
be prevented from selling some of its products. Approximately 58% of Stratagenes revenue in both the first six months of
2004 and for the full year in 2003 came from products sold pursuant to license
agreements. If Stratagene loses the rights to a patented technology, it may be
forced to stop selling some of its products or redesign its products and may
lose significant sources of revenues. In addition, potential competitors could
license technologies that Stratagene fails to license. The loss of a
significant license could have a material adverse effect on Stratagenes
business. Stratagenes significant licenses include a license from Hoffman La
Roche and Roche Molecular Systems, Inc., which we refer to collectively as
Roche, which includes rights to use PCR and Taq polymerase in its research
efforts and rights to manufacture, promote and sell products for PCR for the
research field of use, and a license from Applied Biosystems, which grants
rights to promote and sell thermal cyclers and temperature cycling instruments
as authorized thermal cyclers for the automated performance of PCR for the
research field of use. Each of these license agreements terminates upon the
expiration of the last to expire underlying patent in each agreement. The
agreement with Roche is subject to early termination in the event of the
bankruptcy or insolvency of Stratagene. Roche may also terminate the agreement
(1) for cause or (2) if a third party which is licensed by Roche to manufacture
products for use in PCR-based human diagnostics testing acquires more than 50%
of the voting stock of the Stratagene subsidiary party to the agreement. Since
mid-2003, Stratagene has withheld royalty payments to Roche under this license
agreement while it evaluates a possible overpayment in the royalties paid in
prior periods. Stratagene has continued to record the estimated quarterly
royalty payable under the patent license agreement and reports this amount to
Roche. Management believes that the
royalties calculated and accrued are determined in accordance with
the patent license agreement. However, Stratagenes calculations
of the royalties are subject to review by Roche. Stratagenes
financial position or results of operations could be materially
affected if the parties determine that the royalty calculation
differs significantly from the amounts recorded by Stratagene.
Additionally, there can be no assurances that Stratagene will recover
any of the royalty overpayments. The agreement with Applied Biosystems is subject to early
termination in the event that all claims of the underlying patents in the
agreement are unenforceable or invalid. Applied Biosystems may also terminate
the license agreement (1) for cause, (2) upon a change in control of the
Stratagene subsidiary party to the license agreement or (3) in the event of the
bankruptcy or insolvency of Stratagene. Stratagene does not anticipate that
either of these license agreements will terminate in the near future. The
patent underlying this royalty obligation expires in the United States in March
of 2005. The related foreign patents will expire in 2006 and 2007. Stratagenes licenses also typically subject it to various
commercialization, sublicensing and other obligations. If Stratagene fails to
comply with these requirements, it could lose important rights under a license,
such as the right to exclusivity in a specified market. In some cases,
Stratagene could also lose all rights under a license. In addition, the
licensor could lose patent protection for a number of reasons, including
invalidity of the licensed patent. Stratagene typically does not receive
significant indemnification from a licensor 28




---



##### Table of Contents



against third party claims of intellectual property infringement. Stratagene will face significant challenges in integrating Stratagene and
Hycor and, as a result, may not realize the expected benefits of the merger. The Hycor merger involves the integration of two companies that have
previously operated independently. Combining the operations of Stratagene and
Hycor will be a complex process that will require, among other things,
integration of various functional areas, such as finance, human resources and
sales and marketing groups, and coordination of development efforts.
Stratagene currently anticipates that the integration process will take
approximately 12 months. Stratagene cannot be certain that the integration
will be completed in a timely manner, if at all, or that it will be able to
achieve the anticipated benefits of the merger. For example, the companies may
experience difficulties in harmonizing employee benefit policies, the
relocation of certain job functions may result in the loss of personnel with
critical corporate knowledge and upgrading financial reporting systems to
operate as a single system may lead to interruptions in tracking financial or
sales information. Failure to adequately manage the integration process and to
coordinate the joint efforts of the two companies may have a material adverse
effect on the business of Stratagene. There can be no assurance that the
employees of Hycor will be willing to continue their employment with Hycor
after the merger. There is no assurance that after the merger Stratagene will
be able to maintain all of the existing commercial relationships of Hycor or
Stratagene. Because Stratagenes quarterly revenue and operating results may vary
significantly in future periods, its stock price may decline. Stratagenes operating results have fluctuated in the past and may
continue to fluctuate in the future. In particular, Stratagene has historically
seen slower sales in the fourth quarter as a result of reduced purchases by
academic and research institutions as well as the closing of such facilities
during the holiday period. Stratagenes revenues are unpredictable and may also
fluctuate due to changes in demand for its products, delays in development and
introduction of new products and new product introductions by Stratagenes
competitors. A high proportion of Stratagenes costs are fixed, due in part to
significant research and development costs. Thus, small declines in revenue
could disproportionately affect operating results in a quarter and the price of
the Stratagene common stock may fall. Moreover, a variety of factors may affect
Stratagenes ability to make accurate forecasts regarding its operating
results. Because of these factors, Stratagenes operating results in one or
more future quarters may fail to meet the expectations of securities analysts
or investors, which could cause its stock price to decline. Stratagenes founder, chairman of its board of directors and chief
executive officer exerts considerable control over it. As of June 30, 2004, Dr. Sorge, the founder, chairman of the board of
directors, chief executive officer and president of Stratagene, owned
approximately 62% of Stratagenes outstanding common stock. As a result, Dr.
Sorge controls all matters requiring approval of its stockholders, including
the election of directors and the approval of mergers or other business
combinations. Such a concentration of ownership may have the effect of delaying
or preventing transactions resulting in a change of control of Stratagene,
including transactions where stockholders might otherwise receive a premium for
their shares over then current market prices. Stratagene depends substantially on key employees, and the loss of the
services of any of its key employees or the failure to hire qualified employees
could seriously damage Stratagenes business. To a large degree, Stratagene is dependent on its founder, chairman of its
board of directors and chief executive officer, Joseph A. Sorge, M.D. Dr. Sorge
has significant expertise in the life sciences research market and has been
instrumental in establishing and executing Stratagenes business plan. The loss
of Dr. Sorges services could have a material adverse effect on Stratagenes
business. Dr. Sorge has an existing employment agreement with Stratagene which
expires in June 1, 2007, subject to automatic one year renewals unless either
party provides timely notice of non-renewal. Because Stratagenes products and services are highly technical in nature,
only highly qualified and trained scientists have the necessary skills to
develop and market Stratagenes products and provide Stratagenes services. As
such, Stratagenes future success also will depend in large part on the
continued service of its key scientific and management personnel, including
research and development, customer service, marketing and sales staffs.
Stratagene faces intense competition for these professionals from its
competitors, its customers and other companies throughout its industry.
Stratagene does not generally enter into employment agreements requiring these
employees to continue in its employment for any period of time. Any failure on
Stratagenes part to hire, train and retain a sufficient number of qualified
professionals could seriously damage its business. Stratagenes substantial indebtedness could limit its ability to operate
its business, obtain additional financing and pursue other business
opportunities. 29




---



##### Table of Contents



As of June 30, 2004, Stratagene had approximately $18.7 million of
outstanding indebtedness, including approximately $13.2 million of borrowings
under its senior credit facility, approximately $4.8 million in principal
amount of industrial revenue bonds and an approximately $623,000 mortgage for
its Wyoming facility. Stratagenes substantial amount of indebtedness could
have negative consequences for Stratagene, including the following:  
    
    Stratagene will need a substantial portion of its cash flow to pay
the principal and interest on its indebtedness, including indebtedness
it may incur in the future;
    
    payments of Stratagenes indebtedness will reduce the funds that
would otherwise be available for its operations and future business
opportunities;
    
    Stratagene may have greater debt burdens than its competitors, which
may place Stratagene at a competitive disadvantage;
    
    Stratagenes debt level may make it more vulnerable than its
competitors to a downturn in its business or the economy generally; and
    
    there would be a material adverse effect on Stratagenes business and
financial condition if Stratagene is unable to service its indebtedness
or obtain additional financing. Stratagene may not have financing for future capital requirements, which
may prevent it from addressing gaps in its product offerings or improving its
technology. Although historically Stratagenes cash flow from operations has been
sufficient to satisfy working capital, capital expenditure and research and
development requirements, in the future Stratagene may need to incur additional
debt or issue equity in order to fund these requirements as well as to make
acquisitions and other investments. Stratagene entered into a senior credit
facility in January 2004 that restricts the Companys ability to incur new
debt. If Stratagene cannot obtain additional debt or equity financing on
acceptable terms or is limited with respect to incurring additional debt or
issuing equity, Stratagene may be unable to address gaps in its product
offerings or improve its technology, particularly through strategic
acquisitions or investments. Stratagene may need to raise substantial amounts of money to fund a
variety of future activities integral to the development of its business,
including but not limited to the following:  
    
    for research and development to successfully develop additional products;
    
    to file and prosecute patent applications and defend and assert patents to protect its technology;
    
    to retain qualified employees, particularly in light of intense competition for qualified scientists;
    
    to manufacture additional products itself or through third parties; and
    
    to acquire new technologies, products or companies. If Stratagene raises funds through the issuance of debt or equity, any
debt securities or preferred stock issued will have rights, preferences and
privileges senior to those of holders of the Stratagene common stock in the
event of a liquidation. The terms of the debt securities may impose
restrictions on Stratagenes operations. If Stratagene raises funds through the
issuance of equity, this issuance would dilute your ownership interest in
Stratagene. Stratagene expects to fund future acquisitions in part by issuing
additional equity. If the price of Stratagenes equity is low or volatile, it
may not be able to acquire other companies. Stratagene may spend resources on research and development projects
without being able to achieve an adequate return, if any, on its investment. It is important for Stratagene to continue to invest heavily in research
and development. However, because Stratagene competes in a relatively new and
constantly evolving market, it may pursue research and development projects
that do not result in viable commercial products. In addition, Stratagene has
in the past, and may in the future, terminate research efforts in a particular
area after it has made substantial initial funding commitments in that area.
Any failure to translate research and development expenditures into successful
new product introductions could have an adverse effect on Stratagenes
business. If Stratagene fails to manage its growth effectively, its business could
suffer. A significant portion of Stratagenes historical revenue growth is
attributable to internal product development. Stratagene, being one of the
smaller companies in its industry, is particularly dependent on internal
invention and product development to replace older products in its product
line. Stratagenes ability to achieve its expansion objectives and to manage
its growth effectively depends upon 30




---



##### Table of Contents



a variety of factors, including Stratagenes ability to internally develop
products, to attract and retain skilled employees, to successfully position and
market its products and to identify and acquire technologies and intellectual
property rights from third parties. In addition, Stratagene faces significant
challenges and risks in building and managing its sales team, including
managing geographically dispersed sales efforts and adequately training its
sales people in the use and benefits of its products. To accommodate its growth
and compete effectively, Stratagene will be required to improve its information
systems, create additional procedures and controls and expand, train, motivate
and manage its work force. Stratagenes future success will depend in part on
the ability of current and future management personnel to operate effectively,
both independently and as a group. Stratagene cannot be certain that its
personnel, systems, procedures and controls will be adequate to support its
future operations. The price of the Stratagene common stock is expected to be volatile. The market price of the Stratagene common stock is expected to fluctuate
rapidly. Fluctuations may occur, among other reasons, in response to:  
    
    quarterly fluctuations in Stratagenes operating and earnings per share results;
    
    technological innovations or new product introductions by Stratagene or its competitors;
    
    delays in development and introduction of new products;
    
    disputes concerning patents, licenses or other proprietary rights;
    
    changes in earnings estimates by equity and market research analysts;
    
    sales of common stock by existing holders;
    
    loss of key personnel; and
    
    securities class actions or other litigation affecting Stratagene or other companies in its industry. Any failure to meet analysts expectations could have an adverse effect on
the market price for the Stratagene common stock. In addition, the stock market
is subject to extreme price and volume fluctuations. This volatility has had a
significant effect on the market prices of securities issued by many companies
for reasons unrelated to the operating performance of these companies. In the
past, following periods of volatility in the market price of a companys
securities, securities class action litigation has often been instituted
against that company. If similar litigation were instituted against Stratagene,
it could result in substantial costs and a diversion of Stratagenes
managements attention and resources, which could have an adverse effect on its
business, financial condition and results of operations. In addition,
Stratagene cannot predict the extent to which investors interest in the
Company will lead to a liquid trading market in the Stratagene common stock. Future sales of currently outstanding shares of Stratagene common stock
could adversely affect Stratagenes stock price. As of June 30, 2004, Stratagene had approximately 21.9 million shares of
common stock outstanding. Of this amount, the 5,015,453 shares issued to the
former Hycor stockholders in the merger transaction with Hycor are freely
tradable under the Securities Act, except for any shares held by affiliates of
Stratagene or Hycor, as the case may be, which may be sold from time to time in
accordance with the requirements of Rule 145 of the Securities Act. In
addition, Stratagene has entered into a registration rights agreement with Dr.
Sorge and his affiliates pursuant to which, at the request of Dr. Sorge and
subject to specified conditions, Stratagene will file a registration statement
under the Securities Act covering 2,000,000 shares of Stratagene common stock
held by Dr. Sorge and specified trusts and partnerships controlled by Dr.
Sorge. Dr. Sorge and such trusts and partnerships are also entitled to
register the remaining approximately 11.4 million shares of Stratagene common
stock held by them in specified situations. The shares held by Dr. Sorge and
such trusts and partnerships and the remaining shares of Stratagene common
stock held by the other stockholders of Stratagene prior to the Hycor merger
may also be sold from time to time in the public market subject to the
requirements of Rule 144 under the Securities Act. The sale by Stratagenes
current stockholders of a substantial number of shares, or the expectation that
such sales may occur, could significantly reduce the market price of the
Stratagene common stock. Stratagene has also registered the shares of common stock that it may
issue from time to time under its employee benefits plans. As a result, these
shares can be freely sold in the public market upon issuance, subject to
restrictions under the securities laws. If any of the Companys stockholders
cause a large number of securities to be sold in the public market, the sales
could reduce the trading price of the Stratagene common stock. These sales
also could impede Stratagenes ability to raise future capital. 31




---



##### Table of Contents



Reductions in research and development budgets or government funding may
impact Stratagenes sales. Fluctuations in the research and development budgets of Stratagenes
customers could have a significant effect on the demand for its products.
Research and development budgets fluctuate due to changes in available
resources, spending priorities and institutional budgetary policies.
Stratagenes business could be seriously damaged by any significant decrease in
research and development expenditures by pharmaceutical and biotechnology
companies, academic institutions or government and private laboratories. A substantial portion of Stratagenes sales have been to researchers at
universities, government laboratories and private foundations whose funding is
dependent upon grants from government agencies, such as the United States
National Institutes of Health. Although Stratagene is not aware of any
impending reductions in governmental grants, government funding of research and
development is subject to the political process and as a result the amount of
available funding may decrease. Stratagenes sales may be adversely affected if
its customers delay purchases as a result of uncertainties surrounding the
approval of government budget proposals. A reduction in government funding for
the National Institutes of Health or other government research agencies could
seriously damage Stratagenes business. In recent years, the pharmaceutical and biotechnology industries have
undergone substantial consolidation. Further mergers or corporate
consolidations in these industries could cause Stratagene to lose existing
customers and potential future customers. Pharmaceutical and biotechnology
companies have generally raised little money in the past few years, and some
are low on funds. Some of these companies have begun to reduce their research
and development budgets in recent years. It is possible that these
biotechnology and pharmaceutical companies will continue to reduce spending on
research and development in the future and some companies may go out of
business entirely. In addition, health care reform and other changes in the
regulatory environment affecting these industries could have an adverse impact
on research and development expenditures by pharmaceutical and biotechnology
companies, which would negatively impact Stratagenes business. Stratagenes academic customers generally receive funds from approved
grants at particular times of the year, as determined by the government. Grants
have in the past been frozen for extended periods or have otherwise become
unavailable to various institutions without advance notice. The timing of the
receipt of grant funds affects the timing of purchase decisions by Stratagenes
customers and, as a result, can cause fluctuations in its sales and operating
results. Failure to license new technologies could impair Stratagenes new product
development. In order to meet the needs of its customers, Stratagene must develop a
broad spectrum of products. To build a product line, it is sometimes
advantageous or necessary to license technologies from third parties. As a
result, Stratagene believes its ability to license new technologies from third
parties is and will continue to be important to its ability to offer new
products. Approximately 58% of Stratagenes revenues for both the first six
months of 2004 and for all of 2003, respectively, were attributable to products
manufactured or sold under licenses from third parties. From time to time, Stratagene is notified or becomes aware of patents held
by third parties that are related to technologies Stratagene is selling or may
sell in the future. After a review of these patents, Stratagene may decide to
obtain a license for these technologies from these third parties. Stratagene
can give you no assurance that it will be able to negotiate licenses on
commercially reasonable terms, or at all. Stratagenes ability to gain access to technologies needed for new
products and services depends in part on its ability to convince inventors that
it can successfully commercialize their inventions. Stratagene cannot assure
you that it will be able to continue to identify new technologies developed by
others or that it will be able to negotiate licenses on commercially reasonable
terms, or at all. Stratagene may acquire other businesses or form joint ventures that could
decrease its profitability, dilute your ownership in Stratagene, increase its
debt or cause Stratagene to incur significant expense. As part of Stratagenes business strategy, it intends to pursue
acquisitions of other complementary businesses and technology licensing
arrangements. Stratagene also intends to pursue strategic alliances that
leverage its core technology and industry experience to expand its product
offerings and geographic presence. Stratagene has limited experience with
respect to acquiring other companies and limited experience with respect to the
formation of collaborations, strategic alliances and joint ventures. If
Stratagene were to make any acquisitions, it may not be able to integrate these
acquisitions successfully into its existing business and Stratagene could
assume unknown or contingent liabilities. Any future acquisitions by Stratagene
also could result in large and immediate write-offs or the incurrence of debt
and contingent liabilities, any of which could harm Stratagenes operating
results. Integration of an acquired company also may require management
resources that otherwise would be available for ongoing development of
Stratagenes existing business. Stratagene may not identify or complete these
transactions in a timely manner, on a cost-effective basis, or at all, and 32




---



##### Table of Contents



Stratagene may not realize the anticipated benefits of any acquisition,
technology license or strategic alliance. The absence of qualified senior accounting personnel within Stratagenes
finance department during parts of 2002, 2003 and 2004 has resulted in
diminished oversight of accounting information and reports. In connection with the completion of its audit of, and the issuance of an
unqualified report on, Stratagenes financial statements for the year ended
December 31, 2002, Deloitte & Touche LLP issued a management letter identifying
the absence of qualified senior accounting personnel within Stratagenes
finance department during parts of 2002 and 2003 as a reportable condition
pursuant to standards established by the American Institute of Certified Public
Accountants. A reportable condition is a significant deficiency in the
design or operation of internal control that could adversely affect an entitys
ability to record, process, summarize and report financial data consistent with
the assertions of management in the financial statements. Since the
resignation of Stratagenes former chief financial officer in September 2002,
Dr. Sorge served as Stratagenes chief financial officer. Dr. Sorge does not
have a degree in accounting or a certified public accountants license. In
addition, Stratagene did not have a director of accounting since the
resignation of its former director of accounting in May 2003. In its
management letter, Deloitte & Touche LLP indicated that this lack of qualified
senior staffing in Stratagenes finance department had resulted in a diminished
ability to record, process, summarize and report financial data on a timely and
accurate basis. Deloitte & Touche LLP recommended that Stratagene hire
qualified senior accounting personnel, including a chief financial officer and
a director of accounting, to ensure that accounting information and records are
prepared and reviewed in a timely manner. As disclosed in the Companys registration statement on Form S-4 relating
to the Hycor merger transaction, Stratagene stated that it intended that
Reginald P. Jones, the then chief financial officer of Hycor, would become the
chief financial officer of the Company following the merger and that the
Company would also hire a director of finance. In connection with the closing
of the merger transaction with Hycor, Reginald P. Jones became the chief
financial officer of the Company. In addition, in May 2004 the Company hired a
new director of finance. Inability to secure and maintain intellectual property protection for
Stratagene products and technologies could adversely affect Stratagenes
ability to compete. Stratagenes success depends to a significant degree upon its ability to
develop, maintain and protect proprietary products and technologies. Stratagene
files patent applications in the United States and selectively in foreign
countries as part of its strategy to protect its proprietary products and
technologies. However, patents provide only limited protection of Stratagenes
intellectual property. The assertion of patent protection involves complex
legal and factual determinations and is therefore uncertain and expensive.
Stratagene cannot assure you that patents will be granted with respect to any
of its patent applications, that the scope of any of its issued patents will be
sufficiently broad to offer meaningful protection or that Stratagene will
develop additional proprietary technologies that are patentable. Stratagenes
issued patents or patents licensed to it could be successfully challenged,
invalidated or circumvented so that Stratagenes patent rights would not create
an effective competitive barrier. The loss of a significant patent or the
failure of a patent to issue from a pending patent application that Stratagene
considers significant could have a material adverse effect on Stratagenes
business. The laws governing the scope of patent coverage in the United States and
abroad continue to evolve, particularly in the life sciences area. The laws of
some foreign countries may not protect Stratagenes intellectual property
rights to the same extent as United States laws. Stratagene holds patents only
in selected countries. Therefore, third parties can make, use and sell products
covered by its patents in some countries in which Stratagene does not have
patent protection. Stratagene gives its customers the right to use some of its products under
label licenses that are for research purposes only. These licenses could be
contested and no assurances can be given that Stratagene would either be aware
of an unauthorized use or be able to enforce these restrictions in a
cost-effective manner. Stratagene attempts to protect its trade secrets by entering into
confidentiality agreements with employees, consultants and third parties.
However, these agreements might be breached and, if they are, there may not be
an adequate remedy available to Stratagene. Also, Stratagenes trade secrets
might become known to a third party through means other than by breach of its
confidentiality agreements, or they could be independently developed by
Stratagenes competitors. If Stratagenes trade secrets become known, its
business and competitive position could be adversely affected. 33




---



##### Table of Contents



Intellectual property litigation could seriously harm Stratagenes
business. Litigation involving patents and other intellectual property rights is
pervasive in the biotechnology industry. Stratagene is aware that patents have
been applied for and in some cases issued to others claiming technologies that
are closely related to its own technology. While Stratagene takes steps to
avoid infringing the patents of other parties, Stratagene cannot
assure you that it will not be found to infringe these patents, other patents
or proprietary rights of third parties. As a result, Stratagene periodically
receive notices of potential infringement of patents held by others. Although
Stratagene has generally been successful in resolving these types of claims, it
may not be able to do so in the future. In the event of an intellectual property dispute, Stratagene may become
involved in litigation or arbitration. Litigation could involve proceedings in
court as well as in the United States Patent and Trademark Office or the
International Trade Commission. Intellectual property litigation can be
extremely expensive and may divert managements time and resources away from
Stratagenes operations. Moreover, the outcome of any such litigation is
inherently uncertain. Even a successful outcome may take years to achieve and
the costs associated with such litigation, in terms of dollars spent and
diversion of management time and resources, could seriously harm its business. Recently, Stratagene has been involved in patent disputes with third
parties, a number of which remain unresolved. For example, Stratagene is
involved in litigation with Invitrogen regarding patents relating to specified
reverse transcriptase enzymes and certain competent cell products. Stratagene
is also involved in litigation with Invitrogen and Takara Bio regarding one of
Stratagenes patents related to polymerase blend products. As part of their
patent infringement claims in these matters, the litigants are seeking monetary
damages and attorneys fees. At the present time, Stratagene is unable to
quantify the probability or extent of any potential monetary recovery or
exposure with respect to these matters. If a third party claims an intellectual property right to technology
Stratagene uses, Stratagene may be forced to discontinue an important product
or product line, alter its products and processes, pay license fees, pay
damages for past infringement or cease certain activities. Under these
circumstances, Stratagene may attempt to obtain a license to this intellectual
property, but it may not be able to do so on commercially reasonable terms, or
at all. Changes in distribution and purchasing methods by Stratagenes customers
may force it to use more expensive marketing and distribution channels. A number of Stratagenes customers have developed purchasing initiatives to
reduce the number of vendors they purchase from in order to lower their supply
costs. In some cases, these customers have established agreements with large
distributors, which include discounts and the distributors direct involvement
with the purchasing process. These activities may force Stratagene to supply
these large distributors with its products at a discount to continue to reach
its customers. For similar reasons, many of Stratagenes larger customers,
including the government, have requested and may in the future request special
pricing arrangements, including blanket purchase agreements. To date,
Stratagene does not believe that these special pricing arrangements have had a
material effect on either sales revenues or margins. However, in the future
these agreements may limit Stratagenes pricing flexibility, which could
adversely impact its business, financial condition and results of operations.
In addition, if Stratagene loses one or more of its distributors and cannot
arrange suitable alternatives, its business could be adversely affected. Several of Stratagenes customers have requested that Stratagene sell its
products through third party, e-commerce web sites. While this trend does not
seem to be growing, offering its products through these web sites generally
requires Stratagene to agree to offer volume-related discounts and pay
commissions on the sales made through these web sites to these third party
e-commerce providers. Consequently, margins on sales made through these third
party web sites would generally be lower than those on sales made through
traditional channels. Stratagenes business may be harmed as a result of these
web sites or other sales methods that may be developed in the future. Stratagene relies on third party manufacturers for raw materials and
product components. Stratagene relies on third party manufacturers to supply many of its raw
materials and product components. Some of these components are only available
from a single supplier or a limited group of suppliers, either because the
market for these components is too small to support multiple suppliers or
because the components are protected by patents, in which case there may only
be a single supplier for the covered components. Stratagenes reliance on
outside vendors generally, and a sole supplier or a limited group of suppliers
in particular, involves several risks, including:  
    
    an inability to obtain an adequate supply of required components due
to manufacturing capacity constraints, the discontinuance of a product
by a third-party manufacturer, acquisition of the manufacturer by one of
Stratagenes competitors, or other supply constraints; 34




---



##### Table of Contents




    
    delays and long lead times in receiving materials from vendors; and
    
    reduced control over quality and pricing of components. If a sole source third party supplier were to go out of business,
Stratagene might be unable to find a replacement for such source or it might
take Stratagene several months to be able to make the substances internally. If
a sole source third party supplier were to be acquired by a competitor, that
competitor may elect not to sell to Stratagene in the future. Adverse developments affecting Stratagenes international operations or
foreign currency fluctuations could harm its results from operations. Including sales made by Stratagenes subsidiaries and distributors, its
products are currently marketed in over 45 countries throughout the world.
Measured in U.S. dollars, Stratagenes product sales outside the United States
represented 26% of its total sales for the six months ended June 30, 2004. In
addition, approximately 15% of its total sales for the six months ended June
30, 2004 represents sales exported from the United States. Stratagene expects
that international sales will continue to account for a significant percentage
of its revenues for the foreseeable future, in part because Stratagene intends
to expand its international operations. There are a number of risks arising
from Stratagenes international business, including:  
    
    difficulties and costs associated with staffing and managing foreign operations;
    
    unexpected changes in regulatory requirements;
    
    the difficulties of compliance with a wide variety of foreign laws and regulations;
    
    more limited protection for intellectual property rights in some countries;
    
    changes in Stratagenes international distribution network and direct sales force;
    
    potential trade restrictions and exchange controls;
    
    import and export licensing requirements;
    
    longer accounts receivable collection cycles in certain foreign countries; and
    
    potential increased costs associated with overlapping tax structures. A significant portion of Stratagenes business is conducted in currencies
other than the U.S. dollar, which is its reporting currency. Stratagene
recognizes foreign currency gains or losses arising from its operations in the
period incurred. As a result, currency fluctuations among the U.S. dollar and
the currencies in which Stratagene does business could adversely affect its
results of operations. Stratagene cannot predict the effects of exchange rate
fluctuations upon its future operating results because of the number of
currencies involved, the variability of currency exposures and the potential
volatility of currency exchange rates. Stratagene engages in foreign currency
exchange hedging transactions to manage its foreign currency exposure, but it
cannot assure you that its strategies will adequately protect its operating
results from the effects of exchange rate fluctuations. Stratagene activities involve hazardous materials and may subject it to
costly environmental liability. Stratagene uses hazardous materials, including phenol, chloroform and
ethanol, and radioactive isotopes in connection with its research and
development activities, as well as in its manufacturing processes and in
evaluating the performance of various products. Stratagene is subject to
federal, state and local laws and regulations governing the use, manufacture,
storage, handling and disposal of these materials and specified waste products.
The risk of accidental contamination of property or injury to individuals from
these materials cannot be completely eliminated. In the event of such an
accident, Stratagene could be liable for any damages that result, which could
have a material adverse effect on its business, financial condition and results
of operations. Stratagene carries insurance for contamination resulting from
the use of hazardous materials with $25,000 limitations per incident with
respect to pollution clean-up and removal and radioactive contamination.
Additionally, any accident could partially or completely shut down Stratagenes
research and manufacturing facilities and operations. Stratagene may also have
to incur substantial costs to comply with current or future environmental laws
and regulations. Interruptions in its manufacturing operations could adversely impact
Stratagenes ability to effectively operate its 35




---



##### Table of Contents



business. Stratagene maintains manufacturing facilities in San Diego, California,
Garden Grove, California and in the Austin, Texas area. Damage to these
facilities due to fire, earthquake or other natural disaster, power loss,
unauthorized entry or other events could cause an interruption in the
production of Stratagenes products. Stratagene does not have or plan to obtain
earthquake insurance. In late 1999 and early 2000 Stratagene opened a
manufacturing facility outside of Austin, Texas and moved over 100 jobs to that
location. During the transition process, Stratagene lost some key personnel who
were important to certain manufacturing processes. As a result, Stratagene was
unable to manufacture certain products for a period of three to six months.
Many of the customers who wanted to purchase the affected products during this
period switched to other suppliers and Stratagene found it difficult to
reacquire these customers once it was able to manufacture the products again. A
prolonged interruption in its manufacturing operations could have a material
adverse impact on Stratagenes ability to effectively operate its business. If its biological products and instruments are not properly produced or
manufactured, Stratagene could incur substantial unexpected expenses,
experience product returns and suffer damage to its brand and reputation. Stratagenes biological products and instruments are complex and may be
improperly produced or manufactured. In the past, Stratagene has voluntarily
recalled several of its products. In each case, the problem was identified by
Stratagene and corrected. If Stratagenes products need to be recalled, it
could experience decreased sales and loss of customers and market share. In
addition, a recall would divert managerial and financial resources and could
harm Stratagenes reputation with customers. If Stratagenes access to necessary tissue samples is restricted or
ethical concerns surrounding the use of genetic information become widespread,
its business could suffer. Stratagene requires access to human and other tissue samples and other
biological materials to continue to develop its products. Stratagene competes
with many other companies for these materials and may not be able to obtain or
maintain access to these materials on acceptable terms, or at all. In addition,
genetic testing has raised ethical issues regarding confidentiality and the
appropriate use of the resulting information. Governmental regulation in the
United States and foreign countries could limit access to, or use of, human and
other tissue samples or restrict the use of, or regulate, genetic testing. If
Stratagene loses access to sufficient numbers or sources of tissue samples, or
if tighter restrictions are imposed on Stratagenes customers use of the
information generated from tissue samples, its business could suffer. Anti-takeover provisions of Stratagenes certificate of incorporation and
bylaws and provisions of Delaware law could delay or prevent a change of
control that you may favor. Provisions of Stratagenes amended and restated certificate of
incorporation and amended and restated bylaws may discourage, delay or prevent
a merger or other change of control that stockholders may consider favorable or
may impede the ability of the holders of Stratagenes common stock to change
Stratagenes management. The provisions of Stratagenes amended and restated
certificate of incorporation and amended and restated bylaws, among other
things, authorize Stratagenes board of directors to issue preferred stock in
one or more series, without stockholder approval. Because Stratagene has not chosen to be exempt from Section 203 of the
Delaware General Corporation Law, this provision could also delay or prevent a
change of control that you favor. Section 203 provides that, subject to limited
exceptions, persons that acquire, or are affiliated with a person that
acquires, more than 15 percent of the outstanding voting stock of a Delaware
corporation shall not engage in any business combination with that corporation,
including by merger, consolidation or acquisitions of additional shares, for a
three-year period following the date on which that person or its affiliate
crosses the 15 percent ownership threshold. Additionally, because Dr. Sorge owns approximately 62% of the Companys
outstanding common stock, he controls all matters requiring approval of
Stratagenes stockholders. As a result, among other things, Dr. Sorge must
approve any merger or other business combination related to Stratagene. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk Stratagenes financial instruments include cash and cash equivalents,
investments and long-term debt. At June 30, 2004, the carrying values of its
financial instruments approximated their fair values based on current market
prices and rates. Foreign Currency Translation/Transaction The accounts of foreign subsidiaries and affiliates of Stratagene are
measured using the local currency as the functional currency. 36




---



##### Table of Contents



For these operations, assets and liabilities are translated into U.S.
dollars at period-end exchange rates, and income and expense accounts are
translated at average monthly exchange rates. Net translation gains or losses
are excluded from net income and reflected in accumulated other comprehensive
income (loss) in the accompanying consolidated balance sheets. Stratagenes international sales expose it to foreign currency risk in the
ordinary course of its business. Approximately 26% and 27% of Stratagenes
revenue for the three months ended June 30, 2004 and 2003, respectively, was
generated by Stratagenes foreign subsidiaries. Approximately 27% and 26% of
Stratagenes revenue for the six months ended June 30, 2004 and 2003,
respectively, was generated by its foreign subsidiaries. The foreign
subsidiaries sell products in various local currencies that are collected at
future dates and purchase raw materials and finished goods in both U.S. dollars
and local currencies. Accordingly, Stratagene is exposed to transaction gains
and losses that could result from changes in foreign currency exchange rates.
Realized gains and losses from foreign currency transactions are included in
operations as incurred. For financial reporting purposes, the foreign subsidiaries income
statements are translated from the local currency into U.S. dollars at the
exchange rates in effect during the reporting period. When the local currency
strengthens compared to the U.S. dollar, there is a positive effect on the
foreign subsidiaries sales as reported in Stratagenes consolidated financial
statements. Conversely, when the U.S. dollar strengthens, there is a negative
effect. For the three and six months ended June 30, 2004, the net impact to
Stratagenes reported sales from the effect of exchange rate fluctuations was
an increase of approximately $0.3 million and $1.0 million, respectively, when
compared to the exchange rates for the three and six months ended June 30,
2003. For the three and six months ended June 30, 2004, the net impact to
Stratagenes reported operating expenses from the effect of exchange rate
fluctuations was an increase of approximately $0.3 million and $0.8 million,
respectively, when compared to rates for the three and six months ended June
30, 2003. Derivative Financial Instruments As part of distributing its products, Stratagene regularly enters into
intercompany transactions with its foreign subsidiaries. Stratagenes currency
exposures vary, but are primarily concentrated in the Euro, British Pound,
Swiss Franc and Japanese Yen. Stratagene periodically enters into derivative
instruments to mitigate foreign currency risk on its European revenues,
however, such derivative instruments do not qualify for hedge accounting under
the provisions of SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities,as amended. Accordingly, both unrealized and realized gains
or losses resulting from changes in fair value are recognized as incurred in
gain (loss) on foreign currency transactions in the current period income
statement. Stratagene manages its foreign currency exposure over a maximum of 12
months. At June 30, 2004 and 2003, Stratagene had outstanding foreign currency
exchange contracts, maturing through September 2004 and 2003, with contract
amounts of $6.7 million and $6.4 million, respectively. Fair Value of Financial Instruments The carrying amounts of cash, marketable securities, restricted cash,
foreign currency exchange contracts, accounts receivable, prepaid expenses and
other current assets, accounts payable, accrued expenses, other current
liabilities, and lines of credit are considered to be representative of their
respective fair values because of the short-term nature of these financial
instruments. The carrying amount of the long-term debt is a reasonable estimate
of fair value, as the loans have terms based on market rates. Interest Rates Stratagenes cash and cash equivalents are generally invested in money
market accounts and short-term debt instruments of highly rated credit issuers.
Stratagene limits the amount of credit exposure to any one issuer and seeks to
improve the safety and likelihood of preservation of its invested funds by
limiting default risk and market risk. Based on the Companys short-term
investment portfolio at June 30, 2004, the Company believes that a 10% rise or
fall in interest rates would have had no material impact on its financial
statements. 37




---



##### Table of Contents



The following table shows the average interest rate for the three and six
months ended June 30, 2004 for each of Stratagenes long-term debt obligations: Average Interest Rate for
    
    Average Interest Rate forthe Three Months Ended
    
    the Six Months EndedLong-term Debt Obligations
    
    June 30, 2004
    
    June 30, 2004Term debt
    
    
    5.0
    %
    
    
    5.0
    %Reducing revolving line of credit
    
    
    3.70
    %
    
    
    3.67
    %Subordinated notes
    
    
    15.19
    %
    
    
    15.19
    %Industrial revenue bond
    
    
    1.19
    %
    
    
    1.33
    %Phenogenex promissory note
    
    
    7.5
    %
    
    
    7.5
    %Vehicle financing
    
    Up to 4.5%
    
    Up to 4.5%
 Stratagenes interest income on long-term investments is dependent on the
interest rate attributable primarily to the debt securities purchased by
Stratagene. Since Stratagene generally holds these securities to maturity,
changes in interest rates are not expected to have a material impact on the
value of Stratagenes portfolio. 
 Item 4. Controls and Procedures The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed in the reports filed by the
Company pursuant to the Securities Exchange Act of 1934, as amended, is
recorded, processed, summarized and reported within the time periods specified
in the rules and forms of the Securities and Exchange Commission, and that such
information is accumulated and communicated to management, including the
Companys Chief Executive Officer and Chief Financial Officer, as appropriate,
to allow timely decisions regarding required disclosure. In designing and
evaluating the disclosure controls and procedures, management recognized that
any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives,
and in reaching a reasonable level of assurance, management necessarily was
required to apply its judgment in evaluating the cost-benefit relationship of
possible controls and procedures. The Company carried out an evaluation, under the supervision and with the
participation of management, including its Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Companys disclosure controls and procedures as of the end of the period
covered by this Quarterly Report. Based on the foregoing, the Companys Chief
Executive Officer and Chief Financial Officer concluded that, except as noted
below under Changes in Internal Control, the Companys disclosure controls
and procedures were effective at the reasonable assurance level. Changes in Internal Control There have been no changes in the Companys internal control over
financial reporting during the period covered by this Quarterly Report that
have materially affected, or are reasonably likely to materially affect, the
Companys internal control over financial reporting. However, as disclosed in the Companys registration statement on Form S-4
relating to the merger transaction with Hycor, in connection with its audits of
the Companys fiscal 2002 and 2003 financial statements, Deloitte & Touche LLP,
the Companys independent public accounting firm, identified the absence of
qualified senior accounting personnel within the Companys finance department
during parts of 2002, 2003 and 2004 as a reportable condition pursuant to
standards established by the American Institute of Certified Public
Accountants. A reportable condition is a significant deficiency in the design
or operation of internal control that could adversely affect an entitys
ability to record, process, summarize and report financial data consistent with
the assertions of management in the financial statements. Deloitte & Touche LLP
indicated that this lack of qualified senior staffing in the Companys finance
department resulted in a diminished ability to record, process, summarize and
report financial data on a timely and accurate basis. Accordingly, Deloitte &
Touche LLP recommended that the Company hire qualified senior accounting
personnel, including a chief financial officer and a director of finance, to
ensure that accounting information and records are prepared and reviewed in a
timely manner. As disclosed in the Companys registration statement on Form S-4
related to the Hycor merger transaction, Stratagene stated that it intended
that Reginald P. Jones, the then chief financial officer of Hycor, would become
the chief financial officer of the Company following the merger and that the
Company would also hire a director of finance. In connection with the closing of the merger transaction with Hycor,
Reginald P. Jones became the chief financial officer of the Company. In
addition, in May 2004 the Company hired a new director of finance. As a result
of the hiring of Reginald P. Jones as the Companys new chief financial officer
in connection with the closing of the merger and the other additions made to
the Companys finance department in 2004, the Company is confident that it has
taken the appropriate steps to remedy the reportable condition described above. 38




---



##### Table of Contents



PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings Information regarding legal proceedings is contained in Note 9 to the
Consolidated Financial Statements for the period ended June 30, 2004, which
note is incorporated herein by this reference and is included as part of Item
1. Financial Statements, to this Form 10-Q. 
 Item 4. Submission of Matters to a Vote of Security Holders On June 1, 2004, the stockholders of the Company acted by two separate
written consents to approve the following:  
    
    the merger agreement, as amended, by and among
Stratagene, SHC Acquisition Sub, Inc., a wholly owned subsidiary
of Stratagene, and Hycor Biomedical Inc., pursuant to which SHC
Acquisition Sub was merged with and into Hycor (the Merger),
with Hycor continuing as the surviving corporation and as a
subsidiary of Stratagene;
    
    a second amended and restated certificate of
incorporation which was filed with the Delaware Secretary of State
in connection with the closing of the Merger;
    
    amended and restated bylaws which were adopted and
approved in connection with the closing of the Merger; and
    
    three new employee benefit plans, including the amendment
and restatement of the Year 2000 Stock Option Plan, the 2004
Independent Directors Option Plan and the Stratagene Corporation
Employee Stock Purchase Plan. Stockholders holding an aggregate of 13,095,000 shares approved each of
the above matters and stockholders holding 2,578,918 shares did not vote with
respect to such matters. In addition, on June 1, 2004 the stockholders of the Company acted by
written consent to elect the following five persons to serve as directors of
the Company until the next annual meeting of stockholders or until their
earlier resignation or removal:  
    
    Joseph A. Sorge, M.D.;
    
    Harold S. Eastman;
    
    Carlton J. Eibl;
    
    Stephen A. Kaplan; and
    
    John Reed. All of the persons named above received affirmative votes from
stockholders holding an aggregate of 14,317,918 shares. Stockholders holding
1,356,000 shares did not vote with respect to the election of directors. In
connection with the closing of the Merger, Messrs. Eastman and Kaplan resigned
from the board of directors and were replaced by Messrs. Manion and Tholen. As
of the date of the filing of this Form 10-Q, the Companys board of directors
consists of Dr. Sorge and Messrs. Eibl, Manion, Reed and Tholen. 39




---



##### Table of Contents



Item 6. Exhibits and Reports on Form 8-K  (a)
    
    Exhibits. ExhibitNumber
    
    Description3.1
    
    Second Amended and Restated Certificate of Incorporation of the registrant.3.2
    
    Amended and Restated Bylaws of the registrant.4.1
    
    Registration Rights Agreement dated as of June 2,
2004 by and among the registrant and Joseph A. Sorge, M.D., the
J. A. Sorge Trust I, the J. A. Sorge Trust II, the J. A. Sorge
Trust III, the J. A. Sorge Trust IV, Biosense Partners, L.P. and
the Joseph A. Sorge Charitable Remainder Trust dated December
26, 2002.10.17
    
    Employment Agreement dated as of June 2, 2004 by and
between the registrant and Joseph A. Sorge, M.D.10.18
    
    Unsecured Promissory Note dated as of June 2, 2004
by the registrant in favor of Joseph A. Sorge, M.D.31.1
    
    Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to
18 U.S.C. Section 1350, as created by Section 906 of the
Sarbanes-Oxley Act of 2002.**32.2
    
    Certification of Chief Financial Officer pursuant to
18 U.S.C. Section 1350, as created by Section 906 of the
Sarbanes-Oxley Act of 2002.**
  **
    
    These certifications are being furnished solely to accompany
this quarterly report pursuant to 18 U.S.C. Section 1350, and are not
being filed for purposes of Section 18 of the Securities Exchange Act
of 1934, as amended, and are not to be incorporated by reference into
any filing of the Company, whether made before or after the date
hereof, regardless of any general incorporation language in such
filing.(b)
    
    Reports onForm 8-K. On June 4, 2004, the registrant filed a report on Form 8-K, which reported
under Items 2, 5 and 7 the consummation of the Companys merger transaction
with Hycor Biomedical Inc. 40




---



##### Table of Contents



SIGNATURE Pursuant to the requirements 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. STRATAGENE CORPORATION Date: August 16, 2004
    
    By:
    
    /s/ Joseph A. SorgeJoseph A. Sorge, M.D.Chairman of the Board and Chief Executive Officer(Principal Executive Officer)Date: August 16, 2004
    
    By:
    
    /s/ Reginald P. JonesReginald P. JonesSenior Vice President and Chief Financial Officer(Principal Financial Officer andPrincipal Accounting Officer)
 41