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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 1934  For the quarterly period ended September 30, 2004 OR  [  ]
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934  For the transition period fromto 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  (858) 535-5400
(Registrants telephone number, including area code) 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 October 29, 2004Common Stock, $0.0001 Par Value
    
    22,015,539




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STRATAGENE CORPORATION Quarterly Report on Form 10-Q
Table of Contents PagePart I. Financial InformationItem 1. Financial Statements
    
    
    3Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003 (unaudited)
    
    
    3Consolidated Income Statements for the Three and Nine Months Ended September 30, 2004 (unaudited) and 2003 (as restated) (unaudited)
    
    
    4Consolidated Statements of Cash Flows for the Nine Months Ended September 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
    
    
    19Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    38Item 4. Controls and Procedures
    
    
    39Part II. Other Information
    
    
    41Item 1. Legal Proceedings
    
    
    41Item 6. Exhibits
    
    
    41Signatures
    
    
    42EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  [Note: Items 2, 3, 4 and 5 of Part II are omitted because they are not applicable.] 2




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PART I. FINANCIAL INFORMATION




ITEM I. FINANCIAL STATEMENTS

STRATAGENE CORPORATION AND SUBSIDIARIES




CONSOLIDATED BALANCE SHEETS


(unaudited)


September 30, 2004
    
    December 31, 2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    4,549,984
    
    
    $
    2,003,762Marketable debt securities
    
    
    569,890
    
    
    
    Cash  restricted related to bond indenture
    
    
    420,950
    
    
    
    658,587Foreign currency exchange contracts
    
    
    219,125
    
    
    
    205,110Accounts receivable, less allowance for doubtful
accounts of $666,619 at September 30, 2004 and $990,849
at December 31, 2003
    
    
    10,722,277
    
    
    
    8,390,326Inventories
    
    
    12,208,634
    
    
    
    7,729,655Deferred income tax assets
    
    
    2,412,475
    
    
    
    1,711,947Due from related party, current
    
    
    296,978
    
    
    
    265,639Prepaid expenses and other current assets
    
    
    1,991,265
    
    
    
    2,702,233Total current assets
    
    
    33,391,578
    
    
    
    23,667,259Property and equipment, net
    
    
    11,913,638
    
    
    
    10,320,992Other assets
    
    
    577,909
    
    
    
    696,858Due from related party
    
    
    
    
    
    
    451,630Deferred income tax assets
    
    
    642,160
    
    
    
    Goodwill
    
    
    27,853,723
    
    
    
    Intangible assets, net
    
    
    6,414,317
    
    
    
    2,984,009Investment in joint venture
    
    
    1,279,874
    
    
    
    467,109Total assets
    
    $
    82,073,199
    
    
    $
    38,587,857LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    3,980,478
    
    
    $
    5,003,788Accrued expenses and other liabilities
    
    
    8,497,287
    
    
    
    5,332,114Current portion of long-term debt
    
    
    3,401,667
    
    
    
    920,062Due to related party, current
    
    
    496,243
    
    
    
    268,200Deferred revenue, current
    
    
    731,252
    
    
    
    1,491,976Income taxes payable
    
    
    1,776,376
    
    
    
    1,165,663Total current liabilities
    
    
    18,883,303
    
    
    
    14,181,803Deferred revenue
    
    
    534,261
    
    
    
    Long-term debt, less current portion
    
    
    8,977,447
    
    
    
    29,461,617Due to related party, less current portion
    
    
    1,052,611
    
    
    
    Deferred income tax liabilities
    
    
    
    
    
    
    891,179Total liabilities
    
    
    29,447,622
    
    
    
    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
September 30, 2004 and December 31, 2003
    
    
    
    
    
    
    Common stock, $.0001 par value; 50,000,000 shares
authorized; 22,015,539 and 15,632,668 shares issued and
outstanding at September 30, 2004 and December 31, 2003,
respectively
    
    
    2,202
    
    
    
    1,563Additional paid-in capital
    
    
    52,578,590
    
    
    
    1,821,202Unearned stock-based compensation
    
    
    (554,141
    )
    
    
    Retained earnings (accumulated deficit)
    
    
    1,818,363
    
    
    
    (3,447,340
    )Notes receivable from stockholders
    
    
    

    
    
    
    (3,356,309
    )Accumulated other comprehensive loss
    
    
    (1,219,437
    )
    
    
    (940,514
    )Total stockholders equity (deficit)
    
    
    52,625,577
    
    
    
    (5,921,398
    )Treasury stock, at cost; no shares at September 30, 2004
and 7,040 shares at December 31, 2003
    
    
    
    
    
    
    (25,344
    )Total stockholders equity (deficit)
    
    
    52,625,577
    
    
    
    (5,946,742
    )Total liabilities and stockholders equity (deficit)
    
    $
    82,073,199
    
    
    $
    38,587,857








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STRATAGENE CORPORATION AND SUBSIDIARIES 
 CONSOLIDATED INCOME STATEMENTS
 (unaudited)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(As restated,Note 13)Product sales
    
    $
    23,076,572
    
    
    $
    16,870,659
    
    
    $
    62,245,123
    
    
    $
    50,771,562Costs and expenses:Cost of products sold
    
    
    8,087,522
    
    
    
    5,679,788
    
    
    
    21,138,317
    
    
    
    16,206,239Research and development
    
    
    2,727,998
    
    
    
    2,534,137
    
    
    
    8,059,848
    
    
    
    8,126,277Selling and marketing
    
    
    4,775,211
    
    
    
    3,839,884
    
    
    
    13,098,879
    
    
    
    11,410,701General and administrative
    
    
    3,744,194
    
    
    
    2,493,590
    
    
    
    12,307,715
    
    
    
    7,520,943Impairment of long-lived assets
    
    
    20,226
    
    
    
    33,578
    
    
    
    78,357
    
    
    
    33,578Total costs and expenses
    
    
    19,355,151
    
    
    
    14,580,977
    
    
    
    54,683,116
    
    
    
    43,297,738Income from operations
    
    
    3,721,421
    
    
    
    2,289,682
    
    
    
    7,562,007
    
    
    
    7,473,824Other income and expenses:Loss on foreign currency transactions
    
    
    (134,343
    )
    
    
    (277,783
    )
    
    
    (217,593
    )
    
    
    (326,078
    )Equity in income (loss) of joint venture
    
    
    51,157
    
    
    
    (63,425
    )
    
    
    1,812,765
    
    
    
    (147,935
    )Other income (loss), net
    
    
    665,903
    
    
    
    (38,679
    )
    
    
    749,248
    
    
    
    (31,273
    )Interest expense
    
    
    (248,829
    )
    
    
    (986,684
    )
    
    
    (1,440,116
    )
    
    
    (2,553,120
    )Interest income
    
    
    16,993
    
    
    
    61,937
    
    
    
    133,036
    
    
    
    179,291Total other income (expense)
    
    
    350,881
    
    
    
    (1,304,634
    )
    
    
    1,037,340
    
    
    
    (2,879,115
    )Income before income taxes
    
    
    4,072,302
    
    
    
    985,048
    
    
    
    8,599,347
    
    
    
    4,594,709Income tax expense
    
    
    (1,863,508
    )
    
    
    (377,168
    )
    
    
    (2,857,364
    )
    
    
    (1,579,956
    )Net income
    
    $
    2,208,794
    
    
    $
    607,880
    
    
    $
    5,741,983
    
    
    $
    3,014,753Earnings per share:Basic
    
    $
    0.10
    
    
    $
    0.04
    
    
    $
    0.31
    
    
    $
    0.19Diluted
    
    $
    0.10
    
    
    $
    0.04
    
    
    $
    0.31
    
    
    $
    0.19Weighted average shares:Basic
    
    
    21,941,806
    
    
    
    15,632,668
    
    
    
    18,398,266
    
    
    
    15,632,668Diluted
    
    
    22,077,933
    
    
    
    15,632,668
    
    
    
    18,401,527
    
    
    
    15,632,668
 See accompanying notes to unaudited consolidated financial statements. 4




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STRATAGENE CORPORATION AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (unaudited)
 Nine Months EndedSeptember 30,2004
    
    2003(As restated,Note 13)Cash flows from operating activities:Net income
    
    $
    5,741,983
    
    
    $
    3,014,753Adjustments to reconcile net income to net cash provided by operating activities:Equity in
(income) loss of joint venture
    
    
    (1,812,765
    )
    
    
    147,935Depreciation and amortization
    
    
    2,142,394
    
    
    
    2,036,406Impairment of long-lived assets
    
    
    78,357
    
    
    
    33,578Stock-based compensation
    
    
    726,129
    
    
    
    Bad debt expense
    
    
    (333,258
    )
    
    
    (149,346
    )Excess and obsolete inventory expense
    
    
    (275,716
    )
    
    
    (222,547
    )Loss on disposal of assets
    
    
    4,844
    
    
    
    16,918Interest accrued on notes receivable from stockholders
    
    
    (83,134
    )
    
    
    (133,244
    )Accretion of interest on long-term debt
    
    
    740,842
    
    
    
    2,336,431Deferred income taxes
    
    
    (644,253
    )
    
    
    16,144Changes in assets and liabilities (net of impact of merger with Hycor):Foreign currency exchange contracts
    
    
    (14,015
    )
    
    
    (73,588
    )Accounts receivable
    
    
    820,271
    
    
    
    (559,519
    )Inventories
    
    
    426,823
    
    
    
    (524,506
    )Prepaid expenses and other current assets
    
    
    642,041
    
    
    
    (1,148,583
    )Due from related party
    
    
    96,642
    
    
    
    (165,278
    )Due to related party
    
    
    451,630
    
    
    
    (135,846
    )Income taxes receivable
    
    
    (9,851
    )
    
    
    (71,986
    )Other assets
    
    
    155,880
    
    
    
    102,418Accounts payable
    
    
    (1,605,034
    )
    
    
    128,566Accrued expenses and other liabilities
    
    
    388,990
    
    
    
    1,242,531Deferred revenue
    
    
    (221,085
    )
    
    
    (111,699
    )Income taxes payable
    
    
    430,466
    
    
    
    1,151,423Net cash provided by operating activities
    
    
    7,848,181
    
    
    
    6,930,961Cash flows from investing activities:Cash acquired in merger, net of acquisition costs
    
    
    4,520,153
    
    
    
    Proceeds from maturities of marketable debt securities
    
    
    330,000
    
    
    
    Purchases of property and equipment
    
    
    (867,017
    )
    
    
    (845,796
    )Additions to intangible assets
    
    
    (872,093
    )
    
    
    (809,132
    )Redemption of BCH member interests
    
    
    (7,378
    )
    
    
    Changes in restricted cash
    
    
    237,637
    
    
    
    237,567Cash distributions from joint venture
    
    
    1,000,000
    
    
    
    Net cash (used in) provided by investing activities
    
    
    4,341,302
    
    
    
    (1,417,361
    )
 (Continued) 5




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STRATAGENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited) Nine Months EndedSeptember 30,2004
    
    2003(As restated,Note 13)Cash flows from financing activities:Principal payments on long-term debt
    
    
    (18,744,012
    )
    
    
    (3,136,801
    )Issuance of long-term debt
    
    
    6,000,000
    
    
    
    637,500Borrowings under line of credit
    
    
    8,184,669
    
    
    
    450,000Payments under line of credit
    
    
    (5,000,000
    )
    
    
    (450,000
    )Distributions to BCH members
    
    
    (476,280
    )
    
    
    (363,852
    )Proceeds from issuance of common stock
    
    
    176,284
    
    
    
    Net cash used in financing activities
    
    
    (9,859,339
    )
    
    
    (2,863,153
    )Effects of foreign currency exchange rates on cash
    
    
    216,078
    
    
    
    (604,756
    )Net increase in cash
    
    
    2,546,222
    
    
    
    2,045,691Cash at beginning of period
    
    
    2,003,762
    
    
    
    1,207,892Cash at end of period
    
    $
    4,549,984
    
    
    $
    3,253,583Supplemental disclosure of cash flow information:Cash paid during the period for:Interest
    
    $
    905,236
    
    
    $
    949,044Income taxes
    
    $
    3,085,483
    
    
    $
    461,368Non-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 stockholders
    
    $
    (3,176,059
    )
    
    $
    Deferred taxes recorded in connection with BCH asset purchase
    
    $
    750,000
    
    
    $
    
 (Concluded) See accompanying notes to unaudited consolidated financial statements. 6




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STRATAGENE CORPORATION AND SUBSIDIARIES  
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 September 30, 2004
 1. Basis of Presentation The consolidated financial statements of Stratagene Corporation and its
subsidiaries (Stratagene or the Company) for the three and nine months
ended September 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
September 30, 2004 and the consolidated results of operations and cash flows of
the Company for the three and nine months ended September 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. 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 September 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
are available for current operations and 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)
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




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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 655 fractional shares were
redeemed through a cash payment by Stratagene. Stratagene 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 now 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 issuable upon the exercise of options assumed by Stratagene in
connection with the Hycor merger. 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
 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
in 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
 8




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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 represent $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 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 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 will 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.  
    
    In accordance with the terms of the instrument governing its then
outstanding subordinated notes, Stratagene converted $9.0 million in
principal amount of the subordinated notes into 1,753,604 shares of
Stratagene common stock. As a result of the conversion, there are no
subordinated notes outstanding subsequent to the merger. 9




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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 nine months ended September 30, 2004 and 2003 are as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    23,076,572
    
    
    $
    21,840,128
    
    
    $
    71,211,656
    
    
    $
    65,599,390Net income
    
    $
    2,208,794
    
    
    $
    992,272
    
    
    $
    7,019,540
    
    
    $
    4,153,671Earnings per share:Basic
    
    $
    0.10
    
    
    $
    0.05
    
    
    $
    0.32
    
    
    $
    0.19Diluted
    
    $
    0.10
    
    
    $
    0.04
    
    
    $
    0.32
    
    
    $
    0.19Weighted average shares:Basic
    
    
    21,993,933
    
    
    
    21,927,636
    
    
    
    21,876,343
    
    
    
    21,870,046Diluted
    
    
    22,070,060
    
    
    
    22,438,731
    
    
    
    21,879,604
    
    
    
    22,248,975
 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 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 September 30, 2004, Stratagenes
financial statements are presented on a consolidated basis, 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 of BCH. 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 a joint venture on June
1, 2004. Beginning on June 2, 2004, the consolidated results of Stratagene,
which includes the results of BCH, include 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 in a limited partnership that operates a research lab. The
investment is accounted for under the equity method. 10




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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, one of which is now an
employee of Iobion and one is a consultant 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 nine months ended
September 30, 2004 and 2003, Iobion incurred losses of approximately $245,000
and $625,000, respectively. As of September 30, 2004 and December 31, 2003,
Iobion had accumulated deficits of approximately $766,000 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. In October 2004, the Company purchased the remaining 22%
outstanding membership interests in Iobion owned by these individuals. As a
result of the purchase of these minority interests, Stratagene now owns 100% of
Iobion. Total cash consideration of $330,000 was paid and will be recorded
based on the fair value of the assets and liabilities acquired in the fourth
quarter of 2004. 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
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Weighted average shares:Basic
    
    
    21,941,806
    
    
    
    15,632,668
    
    
    
    18,398,266
    
    
    
    15,632,668Effect of dilutive common stock options
    
    
    136,127
    
    
    
    
    
    
    
    3,261
    
    
    
    Diluted
    
    
    22,077,933
    
    
    
    15,632,668
    
    
    
    18,401,527
    
    
    
    15,632,668
 Options outstanding totaling 2,924,864 and 1,576,796 for the three month
periods ended September 30, 2004 and 2003, respectively, and 2,101,828 and
1,781,962 for the nine month periods ended September 30, 2004 and 2003,
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 inception date of the applicable
stock option plan 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 assumed by Stratagene in the Hycor merger 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 nine
month periods ended September 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
    
    $
    3.70
    
    
    $
    0.00
 11




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##### 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
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income as reported
    
    $
    2,208,794
    
    
    $
    607,880
    
    
    $
    5,741,983
    
    
    $
    3,014,753Stock-based employee
compensation expense
included in reported net
income, net of related
tax effects
    
    
    (28,779
    )
    
    
    
    
    
    
    64,751
    
    
    
    Stock-based compensation
expense determined under
the fair value based
method for all awards,
net of related tax
effects
    
    
    (393,006
    )
    
    
    (1,793
    )
    
    
    (487,666
    )
    
    
    (3,417
    )Pro forma net income
    
    $
    1,787,009
    
    
    $
    606,087
    
    
    $
    5,319,068
    
    
    $
    3,011,336Earnings per common share:Basic  as reported
    
    $
    0.10
    
    
    $
    0.04
    
    
    $
    0.31
    
    
    $
    0.19Basic  pro forma
    
    $
    0.08
    
    
    $
    0.04
    
    
    $
    0.29
    
    
    $
    0.19Diluted  as reported
    
    $
    0.10
    
    
    $
    0.04
    
    
    $
    0.31
    
    
    $
    0.19Diluted  pro forma
    
    $
    0.08
    
    
    $
    0.04
    
    
    $
    0.29
    
    
    $
    0.19
 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 Inventories 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: September 30,
    
    December 31,2004
    
    2003Raw materials and supplies
    
    $
    5,343,038
    
    
    $
    4,314,445Work-in-process
    
    
    3,385,519
    
    
    
    1,612,335Finished goods
    
    
    3,480,077
    
    
    
    1,802,875Total
    
    $
    12,208,634
    
    
    $
    7,729,655
 Intangible Assets and Goodwill The following sets forth the Companys intangible assets by major asset
class: September 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
    
    $
    6,870,547
    
    
    $
    3,095,174
    
    
    $
    3,775,373
    
    
    $
    5,651,019
    
    
    $
    2,667,010
    
    
    $
    2,984,009Amortizable intangible assets
    
    1  5 years
    
    $
    1,189,000
    
    
    $
    125,056
    
    
    $
    1,063,944
    
    
    $
    
    
    
    $
    
    
    
    $
    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




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Amortization expense totaled $267,177 and $98,726 for the three months
ended September 30, 2004 and 2003, respectively. Amortization expense totaled
$553,220 and $336,400 for the nine months ended September 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
    
    
    480,054Thereafter
    
    
    820,469Total
    
    $
    4,839,317
 Accrued Expenses and Other Liabilities Accrued expenses and other liabilities consist of the following: September 30,
    
    December 31,2004
    
    2003Accrued compensation
    
    $
    2,581,942
    
    
    $
    1,302,102Accrued royalties
    
    
    3,881,325
    
    
    
    2,310,744Warranty
    
    
    443,876
    
    
    
    596,788Other accrued expenses and liabilities
    
    
    1,590,144
    
    
    
    1,122,480Total
    
    $
    8,497,287
    
    
    $
    5,332,114
 6. Long-Term Debt The Company has several debt instruments bearing interest at variable
rates (up to 5.75% as of September 30, 2004), 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 September 30, 2004. Long-term debt and line of
credit consist of the following: September 30,
    
    December 31,2004
    
    2003Term loan in the amount of
$6,000,000 bearing interest at
prime plus 1% (5.75% at September
30, 2004)
    
    $
    4,444,444
    
    
    $
    Reducing revolving line of credit
not to exceed $9,000,000 bearing
interest at LIBOR plus 2.55% (4.39%
at September 30, 2004)
    
    
    3,184,670
    
    
    
    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 1.32% and 1.33% for the
three and nine months ended
September 30, 2004, respectively
(1.75% at September 30, 2004 and
1.65% at December 31, 2003)
    
    
    4,750,000
    
    
    
    5,620,000Phenogenex promissory note
    
    
    
    
    
    
    630,074Vehicle financing
    
    
    
    
    
    
    146,50412,379,114
    
    
    
    30,381,679Current portion of long-term debt
    
    
    3,401,667
    
    
    
    920,062Long-term debt, less current portion
    
    $
    8,977,447
    
    
    $
    29,461,617
 13




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##### Table of Contents



The aggregate maturities of long-term debt principal payments for each of
the five years subsequent to September 30, 2004 are as follows: PrincipalPaymentLess than one year
    
    $
    3,401,667One year
    
    
    2,049,702Two years
    
    
    3,450,319Three years
    
    
    265,650Four years
    
    
    156,775Thereafter
    
    
    3,055,000Total
    
    $
    12,379,113
 7. Comprehensive Income Components of comprehensive income, net of income taxes, were as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    2,208,794
    
    
    $
    607,880
    
    
    $
    5,741,983
    
    
    $
    3,014,753Foreign currency translation gain (loss)
    
    
    61,945
    
    
    
    (61,906
    )
    
    
    (279,919
    )
    
    
    56,122Unrealized gains on securities
    
    
    263
    
    
    
    
    
    
    
    996
    
    
    
    Comprehensive income, net of tax
    
    $
    2,271,002
    
    
    $
    545,974
    
    
    $
    5,463,060
    
    
    $
    3,070,875
 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 $25,000 of the fair
market value of the common stock per calendar year, withheld through payroll
deductions to purchase shares of common stock under the ESPP. The 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 purchase date, whichever is lower.
The initial quarterly purchase period began on July 1, 2004. During the
initial offering period ended September 30, 2004, 11,965 shares of common stock
were issued under the plan from proceeds raised of $72,149. 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 14




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##### Table of Contents



Texas. Invitrogen alleges (1) that Stratagene willfully infringed United
States patent no. 4,981,797 for making, using and selling competent E. coli
cell products and (2) 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. This action is
currently stayed pending resolution of the Takara Bio litigation on the same
patent, described below. Invitrogen has also sought 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 entered into a
joint stipulation to stay the proceedings to pursue settlement, which ended in
August 2004. While the parties continue to pursue settlement, the litigation
is proceeding. No trial date is currently set. Third Wave Technologies In September 2004, Stratagene was sued by Third Wave Technologies, Inc. in
the United States District Court for the Western District of Wisconsin. The
complaint alleges that Stratagene infringes United States patent nos. 6,348,314
and 6,090,543, and has induced or contributed to infringement of the
patents-in-suit, by making, using, importing, offering for sale or selling
assays employing cleavage of nucleic acids. Third Wave seeks a preliminary and
permanent injunction, monetary damages (compensatory and enhanced), and
recovery of its attorneys fees and costs. In October 2004, Stratagene filed
its answer to the complaint responding that it does not infringe a valid or
enforceable claim of either patent. Stratagene also asserted affirmative
defenses, including invalidity and unenforceability. Stratagene is seeking an
award of its fees and costs incurred in defending itself in this action. Applera Corporation On November 9, 2004, Stratagene received notice of a patent infringement
suit filed by Applera Corporation against it and other parties in the United
States District Court for the District of Connecticut for alleged infringement
of U.S. patent no. 6,814,934. The Stratagene products alleged to infringe are
the Mx4000 and Mx3000P instruments and certain related reagents. Although it
has not yet been formally served with the complaint, Stratagene is in the
process of evaluating the allegations set forth in the complaint. Accordingly,
an estimate of the possible loss or range of loss cannot be made at this time
and Stratagene is unable to determine whether the outcome of the litigation
could have a material impact on its results of operations or financial
condition in any future period. Other Legal Matters Pursuant to the terms of a litigation settlement in 2002, Stratagene is
entitled to receive 35,290 shares of a European company. Stratagene received
11,763 shares in August 2004 and an additional 11,764 shares in September 2004.
These shares were sold and converted into cash upon receipt, resulting in a
gain of approximately $664,000 in other income during the quarter ended
September 30, 2004. Because of 15




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uncertainties in the collectibility of the remaining
11,763 shares, the Company has not recorded any gain related to these shares as
of September 30, 2004. Royalty Payments Accrued expenses and other liabilities in the September
30, 2004 and December 31, 2003 balance sheets include $3.4 million and $1.7
million, respectively, of accrued royalties due to an unrelated third party
license holder for estimated royalties due from the second quarter of 2003
through the respective balance sheet date. The Company has accrued royalties under this patent
license agreement based on an estimate of the amounts payable in accordance
with the terms of 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 overpayments. Therefore, Stratagenes 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. The patent underlying this royalty obligation expires in the United
States in March of 2005. The corresponding foreign patents will expire in 2006
and 2007. Once the patents expire, Stratagene will no longer be required to pay
royalties on future product sales related to these PCR process patents, which
will result in an approximately $400,000 per quarter reduction in royalty
expense beginning in the second quarter of 2005 and an additional $150,000
reduction beginning in the second quarter of 2006. The Company anticipates
that this decrease in royalty expense will be partially offset by decreases in
the average unit selling price of products using the patented technology
following the expiration of the patents Employment Agreements Stratagene has entered into employment agreements
with certain of its officers. These agreements generally provide for severance
benefits if the officer is terminated by Stratagene other than for cause, as
defined in the employment agreements. See Note 2 for a summary of Dr. Sorges
new employment agreement. Manufacturing move to Texas In June 2004, the Company made the decision
to move the remaining manufacturing operations it conducts in San Diego,
California to its primary manufacturing facility in Austin, Texas. The products
affected by this move represent approximately 32% of total product sales for
the nine months ended September 30, 2004. 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 $120,000, which will be recognized from July 2004 through March
2005, of which approximately $40,000 was accrued for the three months ended
September 30, 2004. The entire estimated obligation is expected to be paid by
the Company by the end of the first quarter in 2005. 10. New Accounting Pronouncements In March 2004, the FASB issued EITF Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments.
EITF No. 03-1 establishes additional disclosure requirements for each category
of SFAS No. 115 investments in a loss position and provides guidance for
assessing impairment losses on investments. Effective for years ending after
December 15, 2003, companies must disclose the aggregate amount of unrealized
losses and the aggregate related fair value of their investments with
unrealized losses. Those investments are required to be segregated by those in
a loss position for less than twelve months and those in a loss position for
greater than twelve months. Additionally, certain qualitative disclosures are
required to clarify a circumstance whereby an investments fair value that is
below cost is not considered other than temporary. In September 2004, the FASB
delayed the provisions of EITF 03-1 which provide guidance on evaluating
whether an impairment is other than temporary. The disclosure requirements
remain effective for annual financial statements. The Company does not expect
that the adoption of this EITF will have a material impact on its financial
position, results of operations and cash flow. 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, 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. 16




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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. This investment is accounted for using the equity
method of accounting. 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 to Stratagene 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 nine months ended
September 30, 2004 includes only four months 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 EndedSeptember 30, 2004
    
    September 30, 2003Research Supplies
    
    Diagnostics
    
    Total
    
    Research Supplies
    
    Diagnostics
    
    TotalProduct sales from external customers
    
    $
    17,464,014
    
    
    $
    5,612,558
    
    
    $
    23,076,572
    
    
    $
    16,870,659
    
    
    $
    
    
    
    $
    16,870,659Income before income taxes
    
    $
    2,808,044
    
    
    $
    1,264,258
    
    
    $
    4,072,302
    
    
    $
    985,048
    
    

    $
    
    
    
    $
    985,048
 Nine Months Ended
    
    Nine Months EndedSeptember 30, 2004
    
    September 30, 2003Research Supplies
    
    Diagnostics
    
    Total
    
    Research Supplies
    
    Diagnostics
    
    TotalProduct sales from external customers
    
    $
    54,539,575
    
    
    $
    7,705,548
    
    
    $
    62,245,123
    
    
    $
    50,771,562
    
    
    $
    
    
    
    $
    50,771,562Income before income taxes
    
    $
    6,718,930
    
    
    $
    1,880,417
    
    
    $
    8,599,347
    
    
    $
    4,594,709
    
    
    $
    
    
    
    $
    4,594,709
 At September 30, 2004 and December 31, 2003, total assets for each
business segment were as follows: September 30,
2004
    
    December 31,
2003Research Supplies
    
    Diagnostics
    
    Total
    
    Research Supplies
    
    Diagnostics
    
    TotalTotal assets
    
    $
    38,044,248
    
    
    $
    44,028,951
    
    
    $
    82,073,199
    
    
    $
    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 derivative instruments, as well as certain other items. Certain
amounts in the income statement for the nine months ended September 30, 2003
are different from amounts previously reported. The income statement for the
three months ended September 30, 2003 is not considered to be restated, as this
period has not been previously reported. The following
discussion provides an overview of the restatement and related adjustments. 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 $114,026 for the nine months ended
September 30, 2003 were reported in gain (loss) on foreign currency
transactions in the income statement. Also, for the nine months ended September 30, 2003, the Company
reclassified $471,981 of realized foreign currency losses associated with its
futures contracts from product sales to gain (loss) on foreign currency
transactions in the income statement. 17




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Other Items As a result of the restatement for the item discussed above, management
deemed it appropriate to record adjustments for certain other known items,
principally related to expense accruals. Certain items have also been reclassified to conform to the current period
presentation. The following summarizes the effect of the restatement on the income
statement: Nine monthsendedSeptember 30,2003Foreign currency futures contracts and hedge accounting
    
    
    (114,026
    )Other items
    
    
    (43,552
    )Pre-tax impact of adjustment to the income statement
    
    
    (157,578
    )Tax benefit impact
    
    
    36,986Total effect on net income
    
    $
    (120,592
    )
 The following table summarizes the effects of the restatement by financial
statement line item affected: Nine months endedSeptember 30, 2003As Previously
    
    AsReported
    
    RestatedIncome StatementFor the nine months ended September 30, 2003:Product sales
    
    
    50,303,630
    
    
    
    50,771,562Cost of products sold
    
    
    16,218,562
    
    
    
    16,206,239Research and development
    
    
    8,127,618
    
    
    
    8,126,277Selling and marketing
    
    
    11,423,990
    
    
    
    11,410,701General and administrative
    
    
    7,500,581
    
    
    
    7,520,943Gain
(loss) on foreign currency transactions
    
    
    259,929
    
    
    
    (326,078
    )Interest expense
    
    
    (2,507,026
    )
    
    
    (2,553,120
    )Income before income taxes
    
    
    4,752,287
    
    
    
    4,594,709Income tax expense
    
    
    (1,616,942

    )
    
    
    (1,579,956
    )Net income
    
    
    3,135,345
    
    
    
    3,014,753
 18




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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. For the nine months ended September 30, 2004, approximately 40%, 56%
and 4% of product sales in the research supplies segment 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. In June
2004, the Company made the decision to move the remaining manufacturing
operations it conducts in San Diego, California to its primary manufacturing
facility in Austin, Texas. Stratagenes sales activities are primarily conducted through a dedicated
direct sales organization in North America and Europe. For the nine months
ended September, 30, 2004, approximately 12% of its product sales in the
research supplies segment 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. Non-U.S.
product sales in the research supplies segment accounted for approximately 29%
of the research supplies segment product sales for the nine months ended
September 30, 2004. 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; 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. 19




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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, 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 has been 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 incurred merger-related costs
of approximately $1.7 million, which were capitalized as a component of the
purchase price. 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 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, with substantially all of the BCH membership
units 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 September 30, 2004, Stratagenes
financial statements are presented on a consolidated basis, 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 income 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 bases of assets and liabilities acquired by Stratagene. Prior to the acquisition date, Stratagene presented its financial
statements on a combined basis with BCH. BCH was a limited liability company
treated as a partnership for income tax purposes; therefore, any related income
tax obligations were the responsibility of the members of BCH. 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, one of which is now an
employee of Iobion and the other is a consultant to the Company. 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 nine months ended September 30, 2004 and 2003,
Iobion incurred losses of approximately $245,000 and $625,000, respectively. As
of September 30, 2004 and December 31, 2003, Iobion had accumulated deficits of
approximately $766,000 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. In October 2004, the Company purchased the
remaining 22% outstanding membership interests in Iobion owned by these
individuals. As a result of the purchase of these minority interests,
Stratagene now owns 100% of Iobion. Total cash consideration of $330,000 was
paid and will be recorded based on the fair value of the assets acquired in the
fourth quarter of 2004. 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 since Hycor was acquired by the Company on June 2, 2004.
The financial information also includes the results of operations of BioCrest
Holdings, LLC, 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 20




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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 research supplies, diagnostic and basic instrumentation
product sales is recognized under the provisions of SAB No. 104, which is
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. 21




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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. In the event that the cash flows expected to be generated by the
asset are not sufficient to recover the carrying value of the asset, an
adjustment for the amount that the carrying value of the asset exceeds its fair
value is recorded as an impairment charge. 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
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 September 30, 2004, the amount of
accrued and unpaid royalties related to this patent license agreement was $3.4
million. The patent underlying this royalty obligation expires in the United
States in March of 2005. The corresponding foreign patents will expire in 2006
and 2007. Once the patents expire, Stratagene will no longer be required to pay
royalties on future product sales related to these PCR process patents, which
will result in an approximately $400,000 per quarter reduction in royalty
expense beginning in the second quarter of 2005 and an additional $150,000
reduction beginning in the second quarter of 2006. The Company anticipates
that this decrease in royalty expense will be partially offset by decreases in
the average unit selling price of products using the patented technology
following the expiration of the patents 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 and repair rates that it has in the past. A
significant increase in product return and repair rates could have a material
adverse impact on operating results for the period or periods in which such
items 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. Research and development costs are expensed as
incurred. For the nine months ended September 30, 2004 and for fiscal 2003,
Stratagenes research and development expenses totaled approximately $8.0
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 cover 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 $77 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. 22




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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 September 30, 2004 compared to three months ended
September 30, 2003 Product Sales For the three months ended September 30, 2004, revenue increased $6.2
million or 36.8% compared to the three months ended September 30, 2003. This
increase was primarily attributable to the Company recording three months of
Hycors diagnostics product sales of $5.6 million as a result of the merger on
June 2, 2004. Also contributing to the growth was increased sales of research
supplies products by Stratagene of $0.6 million for the three months ended
September 30, 2004 when compared to the same period in 2003. Sales during the
three months ended September 30, 2004 were also affected by the weakening
dollar resulting in a positive foreign exchange impact to foreign sales of 8.6%
and a 1.4% increase to total worldwide revenue for the three months ended
September 30, 2004 when compared to the three months ended September 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. 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. Gross Profit Gross profit as a percentage of sales decreased 1.3% from 66.3% for the
three months ended September 30, 2003 to 65.0% for the three months ended
September 30, 2004 due to the inclusion of Hycors lower margin diagnostic
products as a result of the merger offset by favorable manufacturing variances
in the three months ended September 30, 2004 as compared to the same period in
2003. In addition, approximately $39,000 in non-cash stock compensation
charges related to the amortization of unvested stock options assumed by
Stratagene in the Hycor merger are included in cost of products sold for the
three months ended September 30, 2004. Research and Development Expenses Research and development expenses increased $0.2 million or 7.7% for the
three months ended September 30, 2004 compared to the same period in 2003. The
increase in spending was primarily due to approximately $0.4 million of Hycors
diagnostic research and development efforts, which includes approximately
$22,000 in non-cash stock compensation charges related to the amortization of
unvested stock options assumed in the Hycor merger. This increase was offset by
decreased spending in research and development for research supplies by $0.2
million due to transitioning the Mx3000 effort from research and development to
manufacturing in the third quarter of 2003. However, as a percentage of product
sales, research and development expenses decreased from 15.0% for the three
months ended September 30, 2003 to 11.8% for the three months ended September
30, 2004. This decrease in research and development expense as a percentage of
sales is primarily the result of including the diagnostic segment revenue for
the three months ended September 30, 2004. Selling and Marketing Expenses Selling and marketing expenses increased $0.9 million or 24.4% for the
three months ended September 30, 2004 compared to the same period in 2003. The
increase in spending was due to the Company recording three month of Hycor
sales and marketing expenses of approximately $0.9 million. However, as a
percentage of total revenue, selling and marketing expenses decreased from
22.8% for the three months ended September 30, 2003 to 20.7% for the three
months ended September 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 various periods ranging from one to five years beginning
in June of 2004. The amortization expense included in sales and marketing was
approximately $0.1 million for the three months ended September 30, 2004. Also
included is approximately $34,000 of non-cash stock compensation charges
related to the amortization of unvested stock options 23




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assumed in the Hycor merger. See Note 2 to the Companys consolidated
financial statements for the period ended September 30, 2004. General and Administrative Expenses General and administrative expenses increased by $1.3 million or 50.2% for
the three months ended September 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 three months ended September 30, 2003 to 16.2% for the three
months ended September 30, 2004. The increased spending is primarily due to
three months of Hycors general and administrative expenses of approximately
$0.8 million, which includes approximately $31,000 for the amortization of
patents acquired and approximately $55,000 for non-cash stock compensation
charges related to the amortization of unvested stock options assumed in the
Hycor merger, and $0.4 million for additional costs related to public company
oversight. Total Other Income (Expense), Net Total other income, net of expense, increased by $1.7 million or 126.9%
for the three months ended September 30, 2004 compared to the same period in
2003. This increase was primarily due to a reduction in interest expense of
$0.7 million for the three months ended September 30, 2004 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. In addition, the
company further reduced interest expense by paying down approximately $6.4
million in debt during the three months ended September 30, 2004. The Companys
average interest rate on its remaining obligations is approximately 3.8%. Also contributing to the net increase in other income was a gain of $0.7
million as a result of a litigation settlement in 2002. Pursuant to the terms
the settlement, Stratagene is entitled to receive 35,290 shares of a European
company. Stratagene received 11,763 shares in August 2004 and an additional
11,764 shares in September 2004. These shares were sold and converted into cash
upon receipt, resulting in a gain of approximately $664,000 in other income
during the quarter ended September 30, 2004. Because of uncertainties in the
collectibility of the remaining 11,763 shares, the Company has not recorded any
gain related to these shares as of September 30, 2004. Income Taxes Stratagene recorded $1.9 million in tax expense for the three months ended
September 30, 2004, which is approximately 45.8% of pre-tax income as compared
to 38.3% for the three months ended September 30, 2003. The increase in the
effective tax rate was primarily due non-deductible foreign entity losses
resulting from the commencement of operations in Japan. Stratagene recognizes state research and development and other credits
when they are generated. Excess credits for mature operating entities 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. Nine months ended September 30, 2004 compared to nine months ended
September 30, 2003 Product Sales For the nine months ended September 30, 2004, revenue increased $11.5
million or 22.6% as compared to the nine months ended September 30, 2003. This
growth was primarily attributable to the merger with Hycor, which contributed
$7.7 million of diagnostics product sales. Also contributing to the growth was
increased sales of the research supplies product line of $3.8 million for the
nine months ended September 30, 2004 when compared to the same period in 2003.
Sales during the nine months ended September 30, 2004 were also affected by the
weakening dollar resulting in a positive foreign exchange impact to foreign
sales of 10.4% and a 2.1% increase to total worldwide revenue for the nine
months ended September 30, 2004 when compared to the nine months ended
September 30, 2003. 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. Gross Profit Gross profit as a percentage of sales decreased 2.1% from 68.1% for the
nine months ended September 30, 2003 to 66.0% for the 24




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##### Table of Contents



nine months ended September 30, 2004 due to the inclusion of Hycors lower
margin diagnostic products. In addition, approximately $52,000 of non-cash
stock compensation charges related to the amortization of the unvested stock
options assumed in the merger with Hycor were recorded for the nine months
ended September 30, 2004. Research and Development Expenses Research and development expenses decreased $0.1 million or 1.0% for the
nine months ended September 30, 2004 compared to the same period in 2003. The
decrease was primarily due to the inclusion of $0.6 million of Hycor expenses
offset by transitioning the Mx3000P instrument from research and development to
manufacturing in the third quarter of 2003. Research and development expenses
include approximately $0.3 million of non-cash stock compensation expense for
stock options granted to non-employee advisors of Stratagene as well as
approximately $0.1 million in non-cash stock compensation expense related to
the amortization of the unvested stock options assumed in the merger with
Hycor. As a percentage of product sales, research and development expenses
decreased from 16.0% for the nine months ended September 30, 2003 to 12.9% for
the nine months ended September 30, 2004. This decrease was primarily a result
of Hycors research and development efforts being lower as a percentage of the
diagnostic segment sales than Stratagenes research and development efforts as
a percentage of the research supplies segment sales. Selling and Marketing Expense Selling and marketing expenses increased $1.7 million or 14.8% for the
nine months ended September 30, 2004 compared to the same period in 2003. The
increase in spending was due to the Company recording four months of Hycors
sales and marketing expenses of approximately $1.1 million, increased costs
related to Stratagenes Japanese operations of $0.3 million, which commenced in
the second quarter of 2003, and approximately $0.2 million of expenses related
to increased marketing communication activity. As a percentage of total
revenue, selling and marketing expenses decreased 1.5% from 22.5% for the nine
months ended September 30, 2003 to 21.0% for the nine months ended September
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
various periods ranging from one to five years beginning in June of 2004. The
amortization expense included in sales and marketing was approximately $0.1
million for the nine months ended September 30, 2004. Also included was
approximately $45,000 of non-cash stock compensation charges related to the
unvested stock options assumed in the merger with Hycor. See Note 2 to the
Companys consolidated financial statements for the period ended September 30,
2004. General and Administrative Expenses General and administrative expenses increased by $4.8 million or 63.7% for
the nine months ended September 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 nine months ended September 30, 2003 to 19.8% for the nine
months ended September 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, four months of general and administrative expenses
related to the Hycor operations of $1.1 million, which includes approximately
$0.1 million for the amortization of patents and non-cash stock compensation
charges related to the unvested stock options assumed in the merger with Hycor,
$0.7 million of expenses related to increased legal fees associated with patent
litigation and approximately $0.6 million of expense for additional costs
related to public company oversight. Total Other Income (Expense), Net Total other income, net of expense, increased by $3.9 million or 136.0%
for the nine months ended September 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 nine months ended
September 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. In addition, the Company recorded $0.2 million more income from this
49% minority interest companys normal operations when compared to the same
period in 2003. Also contributing to the net increase was a reduction in interest expense
of $1.1 million for the nine months ended September 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.
Subsequent pay offs of other long-term debt obligations further reduced the
interest expense. 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 3.8%. The net increase in other income was also attributable to a gain of $0.7
million as a result of the litigation settlement in 2002. 25




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##### Table of Contents



Income Taxes Stratagene recorded $2.9 million of tax expense for the nine months ended
September 30, 2004. The effective tax rate decreased from 34.4% for the nine
months ended September 30, 2003 to 33.2% for the same period in 2004. The
change in the effective tax rate was primarily a result of BCH recording a gain
in equity in earnings of a joint venture of $1.8 million related to the sale of
certain assets of the joint venture, in which BCH had a minority interest.
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 of BCH. As a result, the operations of BCH did not reflect a provision
for income taxes prior to the acquisition date. 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. The change in effective tax rate was also a result of
non-deductible foreign entity losses. Stratagene recognizes state research and development and other credits
when they are generated. Excess credits for mature operating entities 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 $7.8 million
and $6.9 million for the nine months ended September 30, 2004 and 2003,
respectively. For the nine months ended September 30, 2004, Stratagene generated net
cash from investing activities of $4.3 million and used $1.4 million of net
cash in its investing activities for the nine months ended September 30 2003.
Cash acquired related to the merger with Hycor, net of acquisition costs of
$1.8 million, totaled $4.5 million for the nine months ended September 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 nine
months ended September 30, 2004 and 2003, respectively. Capital expenditures
and additions to patents for the nine months ended September 30, 2004 totaled
$0.9 million and $0.9 million, respectively, as compared to $0.8 million and
$0.8 million for the nine months ended September 30, 2003, respectively. Stratagene used $9.9 million and $2.9 million in net cash for financing
activities for the nine months ended September 30, 2004 and 2003, respectively,
which included the repayment of $23.7 million and $3.6 million in debt offset
by borrowings under the Companys credit facilities of $14.2 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 nine months ended September 30, 2004 was minimal and the
allowance decreased by approximately $0.4 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 $0.8 million for the nine
months ended September 30, 2004 due primarily to collection efforts. Days
sales outstanding decreased from 45 days at December 31, 2003 to 42 days at
September 30, 2004. For the nine months ended September 30, 2003, accounts
receivable used cash of $0.6 million primarily due to strong sales of a new
instrumentation product. Gross inventory provided cash of $0.4 million for the nine months ended
September 30, 2004 due to inventory management efforts. Gross inventory used
$0.5 million due to increased purchases of parts for instrumentation products
during the nine months ended September 30, 2003. Prepaids and other current assets provided cash of $0.6 million for the
nine months ended September 30, 2004 due to allocation of merger related
expenses to goodwill and additional paid-in capital in connection with the
Hycor merger. For the nine months ended 26




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##### Table of Contents



September 30, 2003, prepaids and other current assets used cash of $1.1
million as a result of expenses incurred related to the merger with Hycor. Accounts payable used $1.6 million in cash for the nine months ended
September 30, 2004 due to reducing average days outstanding. Accounts payable
provided cash of $0.1 million for the nine months ended September 30, 2003. Capital expenditures for property and equipment during the nine months
ended September 30, 2004 and 2003 were approximately $0.9 million and $0.8
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 $5.0
million and $2.7 million at September 30, 2004 and December 31, 2003,
respectively, and working capital of $14.5 million and $9.5 million at
September 30, 2004 and December 31, 2003, respectively. As of September 30, 2004, BioCrest Manufacturing, L.P., a consolidated
subsidiary of Stratagene, had approximately $12.4 million in total debt. This
debt included approximately $4.4 million in senior term debt, $3.2 million
under a reducing revolving line of credit and $4.8 million in industrial
revenue bonds. The obligations of BioCrest Manufacturing under the senior credit facility
have been guaranteed by Stratagene and each of its wholly owned domestic
subsidiaries. The obligations are also generally secured by substantially all
of the personal property assets of Stratagene and each of its 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 interest in Iobion
Informatics, LLC. 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 September 30, 2004. The industrial revenue bonds 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 was 1.33% for
the nine months ended September 30, 2004 and was 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 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 September 30, 2004, the purchase commitments covered by these
various key raw materials and other goods and services aggregate approximately
$2,742,000. The following table summarizes the approximate future minimum payments
under the above contractual obligations at September 30, 2004: Payment Due by PeriodLess than
    
    1-3
    
    4-5
    
    After 5Contractual Obligations
    
    Total
    
    1 Year
    
    Years
    
    Years
    
    YearsOperating leases
    
    $
    7,345,858
    
    
    $
    1,982,795
    
    
    $
    4,656,413
    
    
    $
    706,650
    
    
    
    Long-term debt
    
    
    12,379,113
    
    
    
    3,401,667
    
    
    
    5,765,670
    
    
    
    396,776
    
    
    
    2,815,000Note payable to related party
    
    
    1,548,854
    
    
    
    496,243
    
    
    
    1,052,611
    
    
    
    
    
    
    
    Other purchase commitments
    
    
    2,742,000
    
    
    
    2,742,000
    
    
    
    
    
    
    
    
    
    
    
    Total contractual obligations
    
    $
    24,015,825
    
    
    $
    8,622,705
    
    
    $
    11,474,694
    
    
    $
    1,103,426
    
    
    $
    2,815,000
 27




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##### Table of Contents



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
will 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 September
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 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 common stock 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. 28




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##### Table of Contents



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 or medical diagnostic 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 and medical diagnostics 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
medical 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
medical 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 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 29




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##### Table of Contents



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 53% and 58% of Stratagenes revenue in the first nine months
of 2004 and for fiscal 2003, respectively, 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 terms of 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 overpayment in royalties paid in prior periods. The
PCR process patents underlying this royalty obligation expire in the United
States in March of 2005. The corresponding foreign patents will expire in 2006
and 2007. Once the patents expire, Stratagene will no longer be required to
pay royalties on future product sales related to these PCR process patents. 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. 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 against third party claims of
intellectual property infringement. 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 decline. 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 also cause its stock price to decline. 30




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Stratagenes founder, chairman of its board of directors, chief executive
officer and president exerts considerable control over it. As of September 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, chief executive officer and president, 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 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. As of September 30, 2004, Stratagene had approximately $12.4 million of
outstanding indebtedness, including approximately $7.5 million of borrowings
under its senior credit facility and approximately $4.8 million in principal
amount of industrial revenue bonds. 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; 31




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
    
    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. Inability to secure and maintain intellectual property protection for its
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. 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 or other proprietary rights
of third parties. As a result, Stratagene periodically receives 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. 32




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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 Corporation regarding patents relating
to specified reverse transcriptase enzymes and certain competent cell products.
Stratagene is also involved in litigation with Third Wave Technologies relating
to certain assays for detection of nucleic acids. Stratagene is also involved
in litigation with Invitrogen Corporation 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. 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 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 the 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 stockholders;  
    
    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 33




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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 September 30, 2004, Stratagene had approximately 22.0 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 144 or Rule 145 of the Securities Act.
In addition, Stratagene has entered into a registration rights agreement with
Dr. Sorge and certain of 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. 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. 34




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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 53% and 58% of Stratagenes revenues for the first nine
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 no assurances 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 can give no
assurances 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
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. Dr. Sorge served as
Stratagenes chief financial officer from the resignation of Stratagenes
former chief financial officer in September 2002 until the completion of the
Hycor merger in June 2004 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 from May 2003, when its former director of accounting
resigned, until May 2004. 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 in June 2004, Reginald P. Jones became the
chief financial officer of the Company. In addition, in May 2004 the Company
hired a new director of finance. 35




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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 or other proprietary rights
of third parties. As a result, Stratagene periodically receives 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 Corporation regarding patents relating
to specified reverse transcriptase enzymes and certain competent cell products.
Stratagene is also involved in litigation with Third Wave Technologies relating
to certain assays for detection of nucleic acids. Stratagene is also involved
in litigation with Invitrogen Corporation 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 36




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constraints;  
    
    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 nine months ended September 30,
2004. In addition, approximately 13% of its total sales for the nine months
ended September 30, 2004 were for products 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. 37




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Interruptions in its manufacturing operations could adversely impact
Stratagenes ability to effectively operate its 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.
Accordingly, Stratagene believes that 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 September 30, 2004, the carrying values of
its financial instruments approximated their fair values based on current
market prices and rates. 38




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Foreign Currency Translation/Transaction The accounts of foreign subsidiaries and affiliates of Stratagene are
measured using the local currency as the functional currency. 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 22% and 25% of Stratagenes
revenue for the nine months ended September 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 nine months ended September 30, 2004, the net impact
to Stratagenes reported sales from the effect of exchange rate fluctuations
was an increase of approximately $0.5 million and $1.5 million, respectively,
when compared to the exchange rates for the three and nine months ended
September 30, 2003. For the three and nine months ended September 30, 2004, the
net impact to Stratagenes reported operating expenses from the effect of
exchange rate fluctuations was an increase of approximately $0.4 million and
$1.3 million, respectively, when compared to rates for the three and nine
months ended September 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 September 30, 2004 and 2003, Stratagene had outstanding foreign
currency exchange contracts, maturing through December 2004 and 2003, with
contract amounts of $3.6 million and $16.4 million, respectively. The Company
entered into its 2004 contracts during the third quarter of 2003 and does not
plan on entering into its 2005 contracts until the fourth quarter of 2004. 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 September 30, 2004, the Company believes that a 10%
rise or fall in interest rates would have had no material impact on its
financial statements. The following table shows the average interest rate for the three and nine
months ended September 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
    
    September 30, 2004
    
    September 30, 2004Term debt
    
    
    5.41
    %
    
    
    5.15
    %Reducing revolving line of credit
    
    
    4.16
    %
    
    
    3.85
    %Industrial revenue bonds
    
    
    1.32
    %
    
    
    1.33
    %
 39




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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 in
June 2004, 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. 40




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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 September 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 6. Exhibits  (a)
    
    Exhibits. ExhibitNumber
    
    Description10.1
    
    Amendment No. 1 to Credit Agreement dated as of May
26, 2004, by and among Merrill Lynch Business Financial Services
Inc., the registrant, BioCrest Manufacturing, L.P. and BioCrest
Holdings, L.L.C.10.2
    
    Amendment No. 2 to Credit Agreement dated as of
September 28, 2004, by and among Merrill Lynch Business
Financial Services Inc., the registrant, BioCrest Manufacturing,
L.P. and BioCrest Holdings, L.L.C.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. 41




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SIGNATURES 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: November 12, 2004
    
    By:
    
    /s/ Joseph A. Sorge, M.D.Joseph A. Sorge, M.D.Chairman of the Board and Chief Executive Officer(Principal Executive Officer)Date: November 12, 2004
    
    By:
    
    /s/ Reginald P. Jones.Reginald P. JonesSenior Vice President and Chief Financial Officer(Principal Financial Officer andPrincipal Accounting Officer)
 42