##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One)  þ
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934  For the quarterly period ended December 31, 2004 OR  o
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the transition period from to Commission file number 0-28194 DIGENE CORPORATION 
  Delaware
    
    52-1536128(State or other jurisdiction of
    
    (I.R.S. Employer Identification No.)incorporation or organization)1201 Clopper RoadGaithersburg, Maryland
    
    20878(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code (301) 944-7000 (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 þ No o Indicate by check mark whether Registrant is an accelerated filer (as defined in Rule 12b-2 of
the Securities Exchange Act of 1934). þ o
 Indicate the number of shares outstanding of each of the issuers classes of common stock, as of
the latest practicable date. Shares outstanding as ofClass
    
    February 1, 2005(Common Stock, par value $.01 per share)
    
    19,991,830




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##### 



DIGENE CORPORATION INDEX TO FORM 10-Q PagePart I. Consolidated Financial Information:Item 1. Consolidated Financial StatementsConsolidated Balance Sheets-
December 31, 2004 and June 30, 2004
    
    
    3Consolidated Statements of Operations-
Three and six months ended December 31, 2004 and 2003
    
    
    4Consolidated Statements of Cash Flows-
Three and six months ended December 31, 2004 and 2003
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    22Item 4. Controls and Procedures
    
    
    22Part II. Other Information:Item 1. Legal Proceedings
    
    
    23Item 6. Exhibits and Reports on Form 8-K
    
    
    26SignaturesExhibit Index
 2




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##### 



PART I. Consolidated Financial Information
Item 1.   Consolidated Financial Statements DIGENE CORPORATION
CONSOLIDATED BALANCE SHEETS December 31,
    
    
    June 30,2004
    
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    9,213,776
    
    
    $
    4,079,519Short-term investments
    
    
    30,538,113
    
    
    
    44,653,599Accounts receivable, less allowance of approximately $605,000 and $600,000
at December 31, 2004 and June 30, 2004, respectively
    
    
    17,013,852
    
    
    
    17,545,133Inventories
    
    
    7,744,601
    
    
    
    8,109,987Prepaid expenses and other current assets
    
    
    4,093,510
    
    
    
    2,392,048Deferred tax asset, current
    
    
    812,027
    
    
    
    1,047,766Total current assets
    
    
    69,415,879
    
    
    
    77,828,052Property and equipment, net
    
    
    10,305,984
    
    
    
    9,561,794Intangible assets, net
    
    
    900,515
    
    
    
    900,515Deposits and other assets
    
    
    1,403,253
    
    
    
    1,249,971Deferred tax asset, net
    
    
    15,989,144
    
    
    
    13,729,916Total assets
    
    $
    98,014,775
    
    
    $
    103,270,248LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    6,254,982
    
    
    $
    5,423,628Accrued expenses
    
    
    4,481,081
    
    
    
    3,771,141Accrued payroll
    
    
    3,214,916
    
    
    
    5,387,129Current portion of long-term debt
    
    
    115,842
    
    
    
    1,459,890Total current liabilities
    
    
    14,066,821
    
    
    
    16,041,788Deferred rent
    
    
    811,157
    
    
    
    479,078Long-term debt, less current portion
    
    
    627,881
    
    
    
    685,940Minority interest
    
    
    216,474
    
    
    
    Stockholders equity:Preferred stock, $0.10 par value, 1,000,000 shares authorized, no shares
issued and outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 50,000,000 shares authorized, 19,962,881
and 19,883,918 shares issued and outstanding at December 31, 2004
and June 30, 2004, respectively
    
    
    199,629
    
    
    
    198,839Additional paid-in capital
    
    
    140,282,678
    
    
    
    139,637,245Deferred stock compensation
    
    
    
    
    
    
    (164,031
    )Accumulated other comprehensive income
    
    
    1,926,039
    
    
    
    537,688Accumulated deficit
    
    
    (60,115,904
    )
    
    
    (54,146,299
    )Total stockholders equity
    
    
    82,292,442
    
    
    
    86,063,442Total liabilities and stockholders equity
    
    $
    98,014,775
    
    
    $
    103,270,248
 3See accompanying notes.




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##### 



DIGENE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS Three Months Ended
    
    
    Six Months EndedDecember 31,
    
    
    December 31,2004
    
    
    2003
    
    
    2004
    
    
    2003(Unaudited)
    
    
    (Unaudited)Revenues:Product sales
    
    $
    26,506,227
    
    
    $
    20,751,865
    
    
    $
    52,253,164
    
    
    $
    40,243,907Other
    
    
    446,394
    
    
    
    362,348
    
    
    
    910,562
    
    
    
    488,137Total revenues
    
    
    26,952,621
    
    
    
    21,114,213
    
    
    
    53,163,726
    
    
    
    40,732,044Costs and expenses:Cost of product sales
    
    
    5,266,157
    
    
    
    3,722,174
    
    
    
    9,790,718
    
    
    
    7,108,104Royalty and technology
    
    
    1,256,106
    
    
    
    501,466
    
    
    
    2,663,638
    
    
    
    1,020,241Research and development
    
    
    3,189,337
    
    
    
    2,773,711
    
    
    
    5,862,833
    
    
    
    5,628,297Selling and marketing
    
    
    10,021,097
    
    
    
    8,719,337
    
    
    
    19,317,141
    
    
    
    16,613,070General and administrative
    
    
    4,361,427
    
    
    
    4,600,148
    
    
    
    8,922,590
    
    
    
    8,768,860Patent litigation settlement
    
    
    
    
    
    
    
    
    
    
    14,000,000
    
    
    
    Income (loss) from operations
    
    
    2,858,497
    
    
    
    797,377
    
    
    
    (7,393,194
    )
    
    
    1,593,472Other income (expense):Interest income
    
    
    149,781
    
    
    
    100,118
    
    
    
    338,518
    
    
    
    189,941Interest expense
    
    
    (3,849
    )
    
    
    (58,160
    )
    
    
    (25,462
    )
    
    
    (118,681
    )Other income (expense)
    
    
    (21,718
    )
    
    
    228,332
    
    
    
    (59,555
    )
    
    
    210,520Income (loss) before minority
interest and income taxes
    
    
    2,982,711
    
    
    
    1,067,667
    
    
    
    (7,139,693
    )
    
    
    1,875,252Minority interest
    
    
    (41,211
    )
    
    
    
    
    
    
    (216,474
    )
    
    
    Income (loss) before income taxes
    
    
    2,941,500
    
    
    
    1,067,667
    
    
    
    (7,356,167
    )
    
    
    1,875,252Provision for (benefit from)
income taxes
    
    
    2,637,731
    
    
    
    119,303
    
    
    
    (1,386,562
    )
    
    
    271,486Net income (loss)
    
    $
    303,769
    
    
    $
    948,364
    
    
    $
    (5,969,605
    )
    
    $
    1,603,766Basic net income (loss) per share
    
    $
    0.02
    
    
    $
    0.05
    
    
    $
    (0.30
    )
    
    $
    0.09Diluted net income (loss) per share
    
    $
    0.01
    
    
    $
    0.05
    
    
    $
    (0.30
    )
    
    $
    0.08Weighted average shares outstandingBasic
    
    
    19,941,233
    
    
    
    18,837,147
    
    
    
    19,914,573
    
    
    
    18,642,698Diluted
    
    
    20,626,904
    
    
    
    20,810,550
    
    
    
    19,914,573
    
    
    
    20,591,249
 4See accompanying notes.




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##### 



DIGENE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
 Six Months EndedDecember 31,2004
    
    
    2003(Unaudited)Operating activitiesNet income (loss)
    
    $
    (5,969,605
    )
    
    $
    1,603,766Adjustments to reconcile net income (loss) to
net cash
used in operating activities:Depreciation and amortization of property
and equipment
    
    
    2,265,516
    
    
    
    1,829,518Loss on disposal of fixed assets
    
    
    169,447
    
    
    
    Compensation expense related to stock options
    
    
    (89,219
    )
    
    
    298,435Deferred tax benefit
    
    
    (1,855,920
    )
    
    
    Minority interest
    
    
    216,474
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    531,281
    
    
    
    (2,800,109
    )Inventories
    
    
    365,386
    
    
    
    (58,184
    )Prepaid expenses and other current assets
    
    
    (1,701,462
    )
    
    
    89,291Deposits and other assets
    
    
    (153,282
    )
    
    
    (174,435
    )Accounts payable
    
    
    831,354
    
    
    
    (2,825,594
    )Accrued expenses
    
    
    709,940
    
    
    
    74,312Accrued payroll
    
    
    (2,172,213
    )
    
    
    (984,688
    )Deferred rent
    
    
    332,079
    
    
    
    31,616Net cash used in operating activities
    
    
    (6,520,224
    )
    
    
    (2,916,072
    )Investing activitiesPurchases of short-term investments
    
    
    (6,043,368
    )
    
    
    (14,165,607
    )Sales and maturities of short-term investments
    
    
    20,171,761
    
    
    
    15,898,308Capital expenditures
    
    
    (3,179,153
    )
    
    
    (3,014,120
    )Net cash provided by (used in) investing activities
    
    
    10,949,240
    
    
    
    (1,281,419
    )Financing activitiesExercise of common stock options
    
    
    899,473
    
    
    
    11,114,087Principal payments of long-term debt
    
    
    (1,402,107
    )
    
    
    (696,954
    )Net cash (used in) provided by financing activities
    
    
    (502,634
    )
    
    
    10,417,133Effect of currency translations
    
    
    1,207,875
    
    
    
    754,676Net increase in cash and cash equivalents
    
    
    5,134,257
    
    
    
    6,974,318Cash and cash equivalents at beginning of period
    
    
    4,079,519
    
    
    
    7,883,129Cash and cash equivalents at end of period
    
    $
    9,213,776
    
    
    $
    14,857,447
 5See accompanying notes.




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##### 



DIGENE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Basis of Presentation The consolidated financial statements of Digene Corporation (the Company or Digene) for the
three- and six-month periods ended December 31, 2004 and 2003 are unaudited and include all
adjustments which, in the opinion of management, are necessary to present fairly the financial
position and results of operations for the periods then ended. All such adjustments are of a
normal recurring nature, except for the patent litigation settlement
(see Note 6). These
consolidated financial statements should be read in conjunction with the consolidated financial
statements and notes thereto included in our Annual Report on Form 10-K for the year ended June 30,
2004 filed with the Securities and Exchange Commission. The results of operations for any interim period are not necessarily indicative of the results of
operations for any other interim period or for a full fiscal year. Certain prior year amounts have been reclassified to conform to current year presentation. 2. Recent Accounting Pronouncements In December 2004, the
Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which requires
all companies to measure compensation cost for all share-based
payments at fair value, including employee stock options, effective for interim or annual periods beginning after June 15, 2005.
SFAS 123R provides two adoption methods. The first method is a modified prospective transition
method whereby a company would recognize share-based employee costs from the beginning of the
fiscal period in which the recognition provisions are first applied as if the fair-value-based
accounting method had been used to account for all employee awards granted, modified, or settled
after the effective date and to any awards that were not fully vested as of the effective date.
Measurement and attribution of compensation cost for awards that are unvested as of the effective
date of SFAS 123R would be based on the same estimate of the grant-date fair value and the same
attribution method used previously under Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (SFAS 123). The second adoption method is a modified
retrospective transition method whereby a company would recognize employee compensation cost for
periods presented prior to the adoption of SFAS 123R in accordance with the original provisions of
SFAS 123; that is, an entity would recognize employee compensation costs in the amounts reported in
the pro forma disclosures provided in accordance with SFAS 123. A company would not be permitted
to make any changes to those amounts upon adoption of SFAS 123R unless those changes represent a
correction of an error. For periods after the date of adoption of SFAS 123R, the modified
prospective transition method described above would be applied. The Company currently expects to
adopt SFAS 123R on July 1, 2005, using the modified prospective method, although the Company
continues to review its options for adoption under this new pronouncement. The
Company is evaluating the impact of SFAS 123R on its financial statements together with
strategies to manage the impact of equity-based compensation expense on its financial statements
in a manner consistent with the impact on peer companies. The Company cannot make assurances
that these strategies, will be comparable to peer companies. Proforma historical
expense is included in Note 5. In December 2004 the FASB also issued SFAS No. 151, Inventory Costs (SFAS 151). SFAS 151
requires abnormal amounts of inventory costs related to idle facility, freight handling and wasted
material 6




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##### 



expenses to be recognized as current period charges. Additionally, SFAS 151 requires that
allocation of fixed production overheads to the costs of conversion be based on the normal capacity
of the production facilities. The standard is effective for fiscal years beginning after June 15,
2005. The Company believes the adoption of SFAS 151 will not have a material impact on its
consolidated financial statements. 3. Other Balance Sheet Information Inventories Inventories are stated at the lower of cost or market. Inventories consist of the following: December 31,
    
    
    June 30,2004
    
    
    2004(unaudited)Finished goods
    
    $
    5,138,559
    
    
    $
    5,516,411Work in process
    
    
    3,240,861
    
    
    
    3,668,683Raw materials
    
    
    1,126,760
    
    
    
    1,207,4159,506,180
    
    
    
    10,392,509Reserve
    
    
    (1,761,579
    )
    
    
    (2,282,522
    )$
    7,744,601
    
    
    $
    8,109,987
 Debt On September 29, 2004, the Company paid the remaining principal and interest of $1,026,028 to
satisfy its obligation under its note to Abbott Laboratories. Deferred Rent In December 2004, the Company increased deferred rent liability by approximately $300,000 to
include an adjustment for previously unrecognized impact of lease escalation provisions. 4. Income Taxes During the fourth quarter of fiscal 2004 the Company reduced its estimate of the valuation
allowance previously established against the Companys deferred tax assets. The realization of
deferred tax assets are contingent upon the generation of future taxable income. Due to the
uncertainty of realization of certain tax benefits, the Company did not reverse the portion of the
valuation allowance established for the net operating loss carryforwards that are related to the
exercise of stock options and the amount of net operating loss carryforwards and research and
development credits expected to expire unused. The benefit from income taxes recorded in the six months ended December 31, 2004 is based on the
Companys estimated annual effective tax rate. Items which caused recorded income taxes to differ
from taxes computed using the statutory federal income tax rate include state income taxes, foreign
losses not benefited and research and development tax credits. The increase in the estimated
annual effective tax rate from the quarter ended September 30, 2004, was due to changes in
projected operating results for the full fiscal year. 7




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##### 



5. Stockholders Equity Common Stock and Per Share Calculation For the three-month periods ended December 31, 2004 and 2003, in conjunction with stock option
exercises, the Company issued 67,972 and 444,410 shares of common stock, and 78,963 and 830,614
shares of common stock for the six-month periods ended December 31, 2004 and 2003, respectively.
The Company received cash proceeds from the exercise of these stock options of approximately
$753,000 and $5,060,000 for the three-month periods ended December 31, 2004 and 2003, and $899,000
and $11,114,000 for the six-month periods ended December 31, 2004 and 2003, respectively. The following table presents the calculation of basic and diluted net income (loss) per share: Three Months Ended
    
    
    Six Months EndedDecember 31,
    
    
    December 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Numerator:Net income (loss)
    
    $
    303,769
    
    
    $
    948,364
    
    
    $
    (5,969,605
    )
    
    $
    1,603,766Denominator:Weighted average shares outstanding  basic
    
    
    19,941,233
    
    
    
    18,837,147
    
    
    
    19,914,573
    
    
    
    18,642,698Dilutive
securities - stock options
    
    
    685,671
    
    
    
    1,973,403
    
    
    
    
    
    
    
    1,948,551Weighted average shares outstanding  diluted
    
    
    20,626,904
    
    
    
    20,810,550
    
    
    
    19,914,573
    
    
    
    20,591,249Basic net income (loss) per share
    
    $
    0.02
    
    
    $
    0.05
    
    
    $
    (0.30
    )
    
    $
    0.09Diluted net income (loss) per share
    
    $
    0.01
    
    
    $
    0.05
    
    
    $
    (0.30
    )
    
    $
    0.08
 For the three-month periods ended December 31, 2004 and 2003, outstanding stock options to
purchase approximately 2,453,000 and 62,000 shares of common stock were not included in the
computation of diluted net income per share because their effect would have been antidilutive since
the exercise prices of such stock options were greater than the average share price of the
Companys stock for the applicable period, respectively. For the six-month period ended December
31, 2003, outstanding stock options to purchase approximately 170,000 shares of common stock were
not included in the computation of diluted net income per share because their effect would have
been antidilutive. None of the stock options outstanding in the six-month period ended December
31, 2004 were included in the computation of diluted net loss per share because the effect on net
loss would have been antidilutive. Stock-Based Compensation The Company recognizes expense for stock-based compensation arrangements in accordance with the
provisions of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to
Employees, and related Interpretations. Accordingly, compensation cost is recognized for the
excess of the estimated fair value of the stock at the grant date over the exercise price, if any.
The Company accounts for equity instruments issued to non-employees in accordance with EITF 96-18,
Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods, or Services. For the three-month periods ended December 31, 2004
and 2003, compensation expense of $60,281 and $73,368, and for the six-month periods ended December
31, 2004 and 2003, compensation (income) expense of $(89,219) and $298,435 was recognized for the
change in fair value of the equity award to non-employees, respectively. 8




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##### 



In accordance with Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based
CompensationTransition and Disclosure, the effect on net income (loss) and net income (loss) per
share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based
employee compensation is as follows: Three Months Ended
    
    
    Six Months EndedDecember 31,
    
    
    December 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Net income (loss), as reported
    
    $
    303,769
    
    
    $
    948,364
    
    
    $
    (5,969,605
    )
    
    $
    1,603,766Add: Stock-based non-employee
compensation (income)
expense included in
reported net income
(loss), net of taxes
    
    
    36,796
    
    
    
    73,368
    
    
    
    (54,459
    )
    
    
    298,435Deduct: Stock-based employee
compensation expense if
SFAS No. 123 had been
applied
to all grants
    
    
    (4,319,221
    )
    
    
    (4,955,343
    )
    
    
    (7,714,803
    )
    
    
    (8,651,497
    )Pro forma net loss
    
    $
    (3,978,656
    )
    
    $
    (3,933,611
    )
    
    $
    (13,738,867
    )
    
    $
    (6,749,296
    )Net income (loss) per share:Basic  as reported
    
    $
    0.02
    
    
    $
    0.05
    
    
    $
    (0.30
    )
    
    $
    0.09Basic  pro forma
    
    $
    (0.20
    )
    
    $
    (0.21
    )
    
    $
    (0.69
    )
    
    $
    (0.36
    )Diluted  as reported
    
    $
    0.01
    
    
    $
    0.05
    
    
    $
    (0.30
    )
    
    $
    0.08Diluted  pro forma
    
    $
    (0.20
    )
    
    $
    (0.21
    )
    
    $
    (0.69
    )
    
    $
    (0.36
    )
 These pro forma amounts stated above are not likely to be representative of the effect on
reported results for future years due to, among other things, the number of stock options granted,
the vesting period of the stock options and the fair value of options to be granted in future
years. Due to the uncertainty of realization of certain tax benefits, the Company did not reverse
the portion of the valuation allowance established for the net operating loss carryforwards that
are related to the exercise of stock options and, therefore, the stock-based employee compensation
expense deducted above is not shown net of tax. Comprehensive Income (Loss) Comprehensive income (loss) for the quarter- and year-to-date ended December 31, 2004 and 2003 was
as follows: Three Months Ended
    
    
    Six Months EndedDecember 31,
    
    
    December 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Net income (loss), as reported
    
    $
    303,769
    
    
    $
    948,364
    
    
    $
    (5,969,605
    )
    
    $
    1,603,766Other comprehensive income:Unrealized gain (loss) on
available-for-sale
securities, net of income
tax benefit (expense) of
$3,962 and $(6,410),
respectively
    
    
    (25,882
    )
    
    
    
    
    
    
    6,497
    
    
    
    Foreign currency
translation gain
    
    
    921,703
    
    
    
    688,665
    
    
    
    1,381,854
    
    
    
    754,676Comprehensive income (loss)
    
    $
    1,199,590
    
    
    $
    1,637,029
    
    
    $
    (4,581,254
    )
    
    $
    2,358,442
   9




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##### 



6. Royalty and Technology Expenses The Company has in-licensed patents to a number of cancer-causing human papillomavirus types,
biological materials and other intellectual property on which it pays royalties, patent maintenance
and other technology access costs. On October 13, 2004, the Company executed a Settlement and License Agreement with Enzo Biochem,
Inc. and its subsidiary Enzo Life Sciences, Inc. (formerly known as Enzo Diagnostics, Inc.)
(collectively, Enzo), to settle patent litigation claims then pending in the United States
District Court for the District of Delaware. Under the Settlement and License Agreement (the Agreement), Digene received an irrevocable,
non-exclusive, royalty-bearing worldwide license under identified Enzo patents. Digene made an
initial payment to Enzo of $16.0 million, of which $2.0 million can be used to offset future
royalty payments under the terms of the Agreement, resulting in $14.0 million in patent litigation
settlement expense. Digene will also pay Enzo royalties on future net sales of products covered by
the license grant, which royalties will be at least $2.5 million for the first annual period,
beginning October 1, 2004 and ending September 30, 2005, and at least $3.5 million for each of the
next four annual periods under the Agreement. Digene is obligated to make such guaranteed minimum
payments in such first five annual periods. Digenes obligation to make royalty payments will end
on April 24, 2018, unless earlier terminated in accordance with the terms of the Agreement. As of December 31, 2004, the Company has accrued additional royalty and technology expense of
$750,000 relating to terms agreed to on October 14, 2004 with Institut Pasteur with respect to a
non-exclusive license to Institut Pasteurs intellectual property concerning the Hepatitis B virus
genome. See Note 8 Contingencies. 7. Warranties The Company reserves 2% of product sales for future standard warranty costs. The reserve is
amortized ratably over the one-year standard warranty. In fiscal 2003 the Company began to offer
its customers extended warranties on its equipment. The revenue from these extended warranties is
deferred and is recognized evenly over the period of the extended warranty. Changes in the
Companys standard and deferred extended warranty revenue during the period are as follows: Six Months EndedDecember 31,2004
    
    
    2003Balance, beginning of period
    
    $
    1,076,652
    
    
    $
    691,450Warranties issued during the period
    
    
    1,241,881
    
    
    
    846,954Changes in liability for pre-existing warranties during the
period, including expirations
    
    
    (1,038,422
    )
    
    
    (706,997
    )Balance, end of period
    
    $
    1,280,111
    
    
    $
    831,407
 10




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8. Contingencies The Company is involved in various claims and legal proceedings of a nature considered normal to
its business including protection of its owned and licensed intellectual property. The Company
records accruals for such contingencies when it is probable that a liability has been incurred and
the amount can be reasonably estimated. These accruals are adjusted periodically as assessments
change or additional information becomes available. In July 2001, Institut Pasteur notified the Company that Institut Pasteur was granted a new U.S.
patent concerning the Hepatitis B virus genome and requested information from Digene regarding
products that may use the technology described in such new patent. The Company and Institut
Pasteur exchanged information regarding this request during the remainder of 2001 and early 2002.
In July 2004, Institut Pasteur contacted the Company to renew license discussions with respect to
such intellectual property concerning the Hepatitis B virus genome. On October 14, 2004, the
Company and Institut Pasteur agreed to the principal terms of a non-exclusive license under such
intellectual property, which include a payment of $750,000 and a royalty on future sales of
licensed products. The $750,000 was included in royalty and technology expense in the statement of
operations in the quarter ended September 30, 2004. In December 2004, the Company and Institut
Pasteur finalized a license agreement to reflect such principal terms and the $750,000 was paid to
Institut Pasteur in January 2005. Through a license agreement with Georgetown University, the Company obtained exclusive, worldwide
rights to United States Patent No. 5,643,715 and corresponding foreign patents and patent
applications relating to human papillomavirus (HPV) type 52, and to United States Patent No.
5,057,411 and corresponding foreign patents relating to the use of the L1 gene sequence to detect
specific human papillomavirus types. Unless terminated earlier, the license agreement will
terminate upon the last to expire of the licensed patent rights. The Company is obligated to make
royalty payments to Georgetown University based on the percentage of net sales of products (as
defined in the license agreement). The Company continues to accrue and pay royalties to Georgetown
University under the license agreement. The Company had been involved in discussions with
Georgetown University related to the interpretation over the calculation of such royalties. The
parties have not been able to resolve the differences in their interpretations of the royalty
calculation. On October 26, 2004, the Company received a copy of a complaint filed by Georgetown University in
the United States District Court for the District of Columbia, that was later served on November
22, 2004, containing allegations related to the royalties dispute and the Companys use of the
licensed patent rights under the license agreement. In its complaint, Georgetown University
alleges that it is entitled to royalties of 8% on net sales of products covered by the license
agreement, that the total amount of unpaid and past-due royalties owed by the Company to Georgetown
University exceeds $2.0 million, that the Companys license rights under the L1 Patent are
terminated under the provisions of the license agreement and that the Company is in breach of the
license agreement for not using its best efforts to develop products covered by the L1 Patent. The
Company asserts that it has complied fully with the terms of its license agreement with Georgetown
University. The Company believes that Georgetown Universitys interpretation of the license
agreement provisions related to the calculation of royalties is not correct, and that the
royalties, when calculated under the provisions of the license agreement, are consistent with the
Companys historical and previously agreed upon calculation of royalties. Moreover, the Company
disputes Georgetown Universitys claim that the rights as they
relate to the L1 Patent are terminated as the Company has complied with all obligations under the license agreement. 11




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##### 



On January 18, 2005, the Company filed an answer to the complaint, along with counterclaims against
Georgetown University stemming from Georgetown Universitys failure to meet certain legal and
fiduciary duties under the license agreement. The Company believes it has strong defenses and
counterclaims against each of the allegations made in the complaint and intends to vigorously
defend against such action, and to aggressively pursue our counterclaims against Georgetown
University if a resolution of this matter cannot be reached. An adverse outcome to such proceeding, however, could subject the Company to significant liabilities or require the
Company to renegotiate the license agreement, or revise the applications or products that use the licensed patents. The Company cannot provide assurances that it would be successful in negotiating
commercially reasonable license terms, if at all, or that any such application or product revisions could be made without significant
delay or cost. 12




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements The following discussion of our financial condition and results of operations should be read in
conjunction with our Consolidated Financial Statements and the related Notes thereto included
elsewhere in this report and in our Annual Report on Form 10-K for the year ended June 30, 2004.
Some of the information that follows are not statements of historical fact, but merely reflect our
intent, belief or expectations regarding the anticipated effect of events, circumstances and
trends. Such statements should be considered as forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995. We believe that our expectations are based
on reasonable assumptions within the bounds of our knowledge of our business and operations.
Factors that might cause or contribute to differences between our expectations and actual results
include: uncertainty of market acceptance of our products by the worldwide medical community; our
need to obtain third-party reimbursement approval from additional government entities, managed care
organizations, and private insurance plans; risk that other companies may develop and market HPV
tests competitive with our own; uncertainty regarding patents and proprietary rights in connection
with our products and products in development; uncertainty to the outcome of patent litigation in
which we are currently engaged; our ability to scale up our manufacturing to the extent demand for
our products increases; our limited sales and marketing experience; the extent of future
expenditures for sales and marketing programs; delay in or failure to obtain regulatory approvals
for our products in development; uncertainty of clinical trial results for our products in
development; uncertainty of future profitability and cash generation from operations; our ability,
if necessary, to obtain requisite additional financing to fund our operations beyond calendar year
2005; risks inherent in international transactions, including those relating to our expansion in
Europe and elsewhere; and other factors as set forth under the caption Risk Factors in our Annual
Report on Form 10-K for the year ended June 30, 2004. Overview Since our incorporation in 1987, we have devoted substantially all of our resources to developing,
manufacturing and marketing our proprietary gene-based testing systems using our patented Hybrid
Capture® technology for the screening, monitoring and diagnosis of human diseases. Since our
inception, we have incurred substantial operating losses, resulting principally from expenses
associated with our research and development programs, including preclinical studies, clinical
trials and regulatory submissions for our products, the expansion of our manufacturing facilities
and our global sales and marketing activities. Our revenues, to a significant extent, have been derived from the sales of our diagnostic tests for
the presence of human papillomavirus (HPV), which, for fiscal 2004, accounted for 83% of total
revenues and, for the six months ended December 31, 2004, accounted for 84% of total revenues. We
expect that the growing acceptance of HPV testing in cervical cancer screening programs, both in
the United States and internationally, will continue to drive the growth in revenues from our HPV
test products in the future. In fiscal 2004, our gross margin (81% for the full fiscal year) improved over fiscal 2003 gross
margin of 79%. In fiscal 2005, we believe that we will be able to sustain gross margin consistent
with fiscal 2004. We calculate gross margin as the difference between product sales and the cost
of product sales, which exclude royalty and technology expense, as a percentage of product sales
for the period. We have in-licensed patents to a number of cancer-causing human papillomavirus types, biological
materials and other intellectual property on which we pay royalties, patent maintenance and other
technology access costs. Our total royalty and technology expenditures are expected to be
approximately 5% to 6% of product sales in fiscal 2005. 13




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##### 



Our sales and marketing expenditures have been, and will continue to be, focused on accelerating
the adoption of HPV testing worldwide. We intend to capitalize on the expanded indications for use
of our HPV test products and the growing acceptance of our HPV test products in the United States
and internationally by physicians, laboratories and health insurance providers by materially
increasing expenditures for sales and marketing programs over the next several quarters. This
increase in expenditures will be primarily directed at our markets in the United States. We believe that we need to emphasize the investments we make in our sales and marketing activities,
which are essential to allow us to capitalize more fully on the potential of our HPV test products.
During fiscal 2004 one significant area of investment was in our European infrastructure and
distribution operations, and we expect to continue such investment for the remainder of fiscal
2005. We are also significantly expanding our sales organization in the United States and
increasing our investment in physician detailing and direct-to-consumer promotion activities. We
expect to increase modestly the size of our investment in research and development for the next
several quarters and emphasize our research and development expenditures in the development of our
next-generation Hybrid Capture platforms and other research and development programs related to HPV
testing. We expect our general and administrative expenses will increase to provide adequate infrastructure
to support greater sales and marketing activities and to support the overall growth of our
business. On October 13, 2004, we executed a Settlement and License Agreement to settle the then-pending
patent litigation with Enzo Biochem, Inc. and its subsidiary Enzo
Life Sciences, Inc. (formerly known as Enzo Diagnostics, Inc.) ( collectively, Enzo). As a result, we recorded a pre-tax charge
of $14 million in patent litigation settlement expense in the quarter ended September 30, 2004.
Additionally, we will pay Enzo royalties on future net sales of products covered by the license
grant. Please see Liquidity and Capital Resources below for a description of the Enzo
settlement. Although we anticipate increasing our expenditures as described above, we expect to generate
operating profit for the remainder of fiscal 2005, although we do not expect that it will exceed
the operating loss so far for the six months ended December 31, 2004. There can be no assurance
that we will meet this goal. 14




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##### 



Results of Operations Three Months
    
    
    
    Three Months
    
    
    
    
    
    
    
    Six Months
    
    
    
    Six MonthsEnded
    
    
    
    Ended
    
    
    
    
    
    
    
    Ended
    
    
    
    EndedDecember 31,
    
    
    
    December 31,
    
    
    
    %
    
    
    
    December 31,
    
    
    
    December 31,
    
    
    
    %2004
    
    
    
    2003
    
    
    change

    
    
    
    2004
    
    
    
    2003
    
    
    
    change($ in thousands)Total revenue
    
    
    $
    26,953
    
    
    
    $
    21,114
    
    
    
    
    28
    %
    
    
    $
    53,164
    
    
    
    $
    40,732
    
    
    
    
    31
    %Product sales
    
    
    
    26,506
    
    
    
    
    20,752
    
    
    
    
    28
    %
    
    
    
    52,253
    
    
    
    
    40,244
    
    
    
    
    30
    %HPV test product revenue
    
    
    
    22,341
    
    
    
    
    17,144
    
    
    
    
    30
    %
    
    
    
    44,790
    
    
    
    
    33,627
    
    
    
    
    33
    %Cost of product sales
    
    
    
    5,266
    
    
    
    
    3,722
    
    
    
    
    41
    %
    
    
    
    9,791
    
    
    
    
    7,108
    
    
    
    
    38
    %Gross margin(1)
    
    
    
    80
    %
    
    
    
    82
    %
    
    
    
    
    
    
    
    
    81
    %
    
    
    
    82
    %Royalty and technology expense
    
    
    $
    1,256
    
    
    
    $
    501
    
    
    
    
    150
    %
    
    
    $
    2,664
    
    
    
    $
    1,020
    
    
    
    
    161
    %
   (1) We calculate gross margin as the difference between product
sales and the cost of product sales, which exclude royalty and technology
expense, as a percentage of product sales for the period. Product sales increased 28% to approximately $26,506,000 for the three-month period ended
December 31, 2004 from approximately $20,752,000 for the corresponding period in fiscal 2004. The
increase was due primarily to a 30% growth in sales of our HPV test products over such sales in the
corresponding period in fiscal 2004. The majority of the growth in our HPV test product revenue
was in the United States, which increased 32% to approximately $17,294,000, and in Europe, which
increased 28% to approximately $3,976,000. Product sales increased 30% to approximately $52,253,000 for the six-month period ended December
31, 2004 from approximately $40,244,000 for the corresponding period in fiscal 2004. The increase
was due primarily to a 33% growth in sales of our HPV test products over such sales in the
corresponding period in fiscal 2004. The majority of the growth in our HPV test product revenue
was in the United States, which increased 35% to approximately $35,377,000, and in Europe, which
increased 32% to approximately $7,299,000. Other revenues include research and development contract revenues, equipment rental revenues and
licensing revenues. Other revenues increased 23% to approximately $446,000 for the three-month
period ended December 31, 2004 from approximately $362,000 for the corresponding period in fiscal
2004. Other revenues increased 87% to approximately $911,000 for the six-month period ended
December 31, 2004 from approximately $488,000 for the corresponding period in fiscal 2004. The
increase for the six-month period ended December 31, 2004 was due primarily to an approximately
$164,000 increase in research and development contract revenue in the current period versus the
corresponding period in fiscal 2004. 15




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##### 



Cost of product sales increased by 41% to approximately $5,266,000 for the three-month period ended
December 31, 2004 from approximately $3,722,000 for the corresponding period in 2004 and increased
38% to approximately $9,791,000 for the six-month period ended December 31, 2004 from approximately
$7,108,000 for the corresponding period in fiscal 2004. The increase for both periods is primarily
due to increased product sales volume. Gross margin percentage on product sales decreased to 80%
for the three-month period ended December 31, 2004 from 82% for the corresponding period in fiscal
2004 and decreased to 81% for the six-month period ended December 31, 2004 from 82% for the
corresponding period in fiscal 2004. The decrease in gross margin percentage for both periods is
the result of increased manufacturing overhead costs, partially offset by a shift in product mix
from lower-margin hepatitis B virus and cytomegalovirus test products to higher-margin HPV test
products and a reduced impact of inventory reserves for obsolescence. Equipment sales increased to
7%, or approximately $1,757,000, of product sales for the three-month period ended December 31,
2004 compared to 6% for the corresponding period in fiscal 2004, and increased to approximately 6%,
or approximately $3,125,000, of product sales for the six-month period ended December 31, 2004
compared to 5% for the corresponding period in fiscal 2004. Royalty and technology expense increased 150% to approximately $1,256,000 for the three-month
period ended December 31, 2004 from approximately $501,000 for the corresponding period in 2004 and
increased 161% to approximately $2,664,000 for the six-month period ended December 31, 2004 from
approximately $1,020,000 for the corresponding period in fiscal 2004. The increase for the
six-month period ended December 31, 2004 is due primarily due to: a charge of $750,000 accrued
during the quarter ended September 30, 2004 relating to a non-exclusive license to Institut
Pasteurs intellectual property concerning the Hepatitis B virus genome; and increased royalty
expenses beginning October 1, 2004 on net sales of our products based on a Settlement and License
Agreement with Enzo Biochem, Inc. and its subsidiary Enzo Life Sciences, Inc., under which we will
pay Enzo royalties on future net sales of products covered by the license grant. Please see
Liquidity and Capital Resources below for a description of the Enzo settlement. Research and development expenses increased 15% to approximately $3,189,000 for the three-month
period ended December 31, 2004 from approximately $2,774,000 for the corresponding period in fiscal
2004 and increased 4% to approximately $5,863,000 for the six-month period ended December 31, 2004
from approximately $5,628,000 for the corresponding period in fiscal 2004. The increase for the
three-month period ended December 31, 2004 was primarily attributed to a 26% increase in personnel
costs to approximately $1,422,000 from approximately $1,132,000 from the corresponding period in
fiscal 2004. The increase for the six-month period ended December 31, 2004 compared to the
corresponding period in fiscal 2004 was largely due to a 29% increase in personnel cost to
approximately $2,988,000, partially offset by a 43% decrease in professional services expenses to
approximately $804,000. The decrease in professional services expenses is largely due to costs no
longer being incurred for the preparation of compliance with the European Union In Vitro Diagnostic
Directive (or IVDD) regulations, which was successfully accomplished for our HPV, chlamydia and
gonorrhea test kits in the second quarter of fiscal 2004, and for which we spent heavily in the
first half of fiscal 2004. Because our research and development expenditures tend to benefit
multiple product offerings, we do not account for research and development expenses on a
per-product or per-disease target basis. During the six-month period ended December 31, 2004, our research and development activities
focused on our platform technology, including adaptations of such technology, and improvements to
our diagnostic test and equipment products. We focused our research and development activities in
four areas: (1) core research efforts for next-generation technologies; (2) new product
development activities; (3) completion of activities necessary to support regulatory submissions to
seek approvals to market our existing products for additional uses and indications in the U.S. and
abroad; and (4) support and improvement of existing product lines and equipment offerings. 16




---



##### 



Our core research efforts for next-generation technologies include research programs with the goal
of developing improved molecular diagnostic assay systems for the detection of HPV and other
targets of interest in the area of womens cancers and infectious diseases, and research on our
next generation of Hybrid Capture technology. We achieved technical feasibility of our next
generation platform proprietary DNA test for ultra-sensitive detection of DNA targets in a highly
multiplexed format and we are exploring core research objectives to begin expanding the menu of
products and infectious disease targets. We have also begun a number of research and development
efforts to explore HPV genotyping products. We continue our collaborative product development and
commercialization agreement with PATH (Program for Appropriate Technology in Health) to develop a
rapid, batch HPV test for developing countries and have successfully completed our first year of
that program. Digene and PATH will jointly fund the efforts subject to certain maximum funding
obligations and Digene will perform the product development and commercialization activities. With respect to our new product development activities and product modification activities, we are
currently focused on the discovery of innovative methods to improve specimen processing procedures
and throughput. This includes procedures for the improved processing of PreservCytTM
Solution (Cytyc Corporation) specimens through a new procedure for high throughput HPV, Chlamydia
trachomatis(CT) and Neisseria gonorrhoeae(GC) testing. We have begun the development of a
clinical sample preparation workstation, which will provide automated capabilities to preparing
clinical specimens for Hybrid Capture testing. We have begun validating the next version of our
DML-software suite, which will provide new features and improvements to the current product
software. We are also working to expand HPV testing capabilities to allow testing from additional
liquid cytology media, including the
SurePathTM
(TriPath Imaging) medium, for which a Pre-Market Approval
(PMA) supplement was submitted by TriPath Imaging to the FDA in August 2004 as part of a continuing collaboration between
Digene and TriPath Imaging. On February 2, 2005, we were informed that TriPath Imaging withdrew
its PMA supplement. Our understanding is that TriPath Imaging took
this action after it learned, through discussions with the FDA, that
additional clinical information and analyses would be required, which
had not been part of the original protocol accepted by the FDA. We
understand that TriPath Imaging intends to work with the FDA with the
goal of resubmitting the PMA supplement as soon as possible. With respect to regulatory submissions and clinical evaluation activities, we continue to work
closely with the FDA regarding the previously submitted 510(k) pre-market notifications and
completion of supplemental clinical work supporting the use of Cytyc Corporations
ThinPrep® PreservCyt Solution as a specimen collection method for our CT and GC tests.
We have begun the necessary clinical study which will continue over the next several months and we
anticipate submitting these study data to the FDA as new 510(k)s to facilitate completion of its
scientific review. We have begun a multi-center clinical evaluation to support a PMA supplement
for our new method of processing liquid-based cytology (LBC) specimens for HPV testing; this
study is also expected to continue over the next several months. This new method will improve and
simplify clinical LBC specimen processing and increase processing throughput. We are nearing
completion of our efforts to CE-mark our Rapid CaptureTM System and associated products
for European Countries, for which we expect product availability by the end of this fiscal year.
Our Rapid Capture System is an automated pipetting and microplate handling platform developed to
accommodate high volume diagnostic testing using our Hybrid Capture technology. 17




---



##### 



Selling and marketing expenses increased 15% to approximately $10,021,000 for the three-month
period ended December 31, 2004 from approximately $8,719,000 for the corresponding period in fiscal
2004 and increased 16% to approximately $19,317,000 for the six-month period ended December 31,
2004 from approximately $16,613,000 for the corresponding period in fiscal 2004. The increase for
the three-month period ended December 31, 2004 was due to personnel costs, which increased 24% to
approximately $3,758,000 and marketing programs, which increased 20% to approximately $2,104,000.
These increases were partially offset by a decrease in agency fees, which decreased 16% to
approximately $1,280,000. The increase for the six-month period ended December 31, 2004 was
primarily due to personnel costs, which increased 31% to approximately $7,530,000 and marketing
programs, which increased 8% to approximately $3,631,000. These increases were partially offset by
a decrease in professional fees, which decreased 11% to approximately $1,234,000 due largely to a
reduction in non-cash stock compensation expense related to a European consultant. General and administrative expenses decreased 5% to approximately $4,361,000 for the three-month
period ended December 31, 2004 from approximately $4,600,000 for the corresponding period in fiscal
2004 and increased 2% to approximately $8,923,000 for the six-month period ended December 31, 2004
from approximately $8,769,000 for the corresponding period in fiscal 2004. The decrease for the
three-month period ended December 31, 2004 was primarily the result of a 29% decrease in
professional services to approximately $1,269,000, largely related to a decrease in legal fees,
partially offset by an increase in personnel costs, which increased 19% to approximately
$2,162,000. The increase for the six-month period ended December 31, 2004 was primarily attributed
to a 15% increase in personnel costs to approximately $4,177,000 and a 34% increase in facility
expenses to approximately $647,000. This increase was partially offset by a 19% decrease in
professional services to approximately $2,723,000, largely related to a decrease in legal fees. Patent litigation settlement charges relate to the October 2004 settlement with Enzo, which was
$14,000,000 for the three- and six-months ended December 31, 2004. Please see Liquidity and
Capital Resources below for a description of the Enzo settlement. Interest income increased to approximately $150,000 for the three-month period ending December 31,
2004 from approximately $100,000 for the corresponding period in 2004 and increased 78% to
approximately $339,000 for the six-month period ended December 31, 2004 from approximately $190,000
for the corresponding period in fiscal 2004. The increases are primarily due to increases in the
market yield on balance of cash, cash equivalents and short-term investments for the three- and
six-months ended December 31, 2004 compared to the corresponding period in fiscal 2004. Other income (expense) consists primarily of foreign exchange transaction gains and losses. Minority interest of approximately $41,000 and approximately $217,000 for the three- and six-month
periods ended December 31, 2004, respectively, represents third party interest in the earnings of
Digene do Brasil LTDA (DDB), a majority-owned subsidiary of the Company. Historically DDB has
had cumulative losses and accordingly minority interest had not been recorded. Significant
intercompany accounts and transactions have been eliminated. During the fourth quarter of fiscal 2004 we reduced our estimate of the valuation allowance
previously established against our deferred tax assets. The realization of total deferred tax
assets is contingent upon the generation of future taxable income. Due to the uncertainty of
realization of certain tax benefits, we did not reverse the portion of the valuation allowance
established for the net operating loss carryforwards that are related to the exercise of stock
options and the amount of net operating loss carryforwards and research and development credits
expected to expire unused. 18




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##### 



The provision for and benefit from income taxes recorded in the three- and six-month periods ended
December 31, 2004, respectively, are based on our estimated annual effective tax rate. Items which
caused recorded income taxes to differ from taxes computed using the statutory federal income tax
rate include state income taxes, foreign losses not benefited and research and development tax
credits. The increase in the estimated annual effective tax rate from the quarter ended September
30, 2004, was due to changes in projected operating results for the full fiscal year. Although our
projected operating results for the full fiscal year result in a net loss, we project income tax
expense because a substantial portion of this net loss is expected to be derived from Europe
and we cannot use Europe net losses to offset net income generated in
the United States. 19




---



##### 



Liquidity and Capital Resources Since inception, our expenses have significantly exceeded our revenues, resulting in an accumulated
deficit of approximately $60,116,000 at December 31, 2004. We have funded our operations primarily
through the sale of equity securities and revenues from product sales and research and development
contracts. At December 31, 2004, we had cash, cash equivalents and short-term investments
aggregating approximately $39,752,000. We had cash used in operations of approximately
$6,520,000 for the six-months ended December 31, 2004 compared to cash used in operations of
approximately $2,916,000 for the comparable period in fiscal 2004. Net cash provided by investing activities for the six-months ended December 31, 2004, of
approximately $10,949,000, included approximately $14,128,000 of net sales and maturities of
short-term investments to pay patent settlement expenses of $16,000,000, as more fully described
below, partially offset by approximately $3,179,000 of capital expenditures. In fiscal 2005, we
expect equipment placed at customer sites and leasehold improvements at our headquarters facility
in Gaithersburg, Maryland, to be significant uses of working capital. The placed equipment,
specifically Rapid Capture Systems, allows our customers to run diagnostic tests using our reagent
test kit products. We have begun to further expand our warehouse capacity, as well as operations,
research and development and general and administrative space at our Gaithersburg facility, for
which we may obtain alternative financing. On October 13, 2004 we entered into a Settlement and License Agreement (the Agreement) to settle
our patent litigation with Enzo Biochem, Inc. and its subsidiary Enzo Life Sciences, Inc. (formerly
known as Enzo Diagnostics, Inc.) (collectively, Enzo). Under the Agreement, we received an
irrevocable, non-exclusive, royalty-bearing worldwide license under identified Enzo patents. We
made an initial payment to Enzo of $16,000,000, of which $2,000,000 can be used to offset future
royalty payments under the terms of the Agreement, resulting in a one-time pre-tax charge of
$14,000,000 in patent settlement expense. We will also pay Enzo royalties on future net sales of
products covered by the license grant, which royalties will be at least $2,500,000 for the first
annual period (October 1, 2004 to September 30, 2005) and at least $3,500,000 for each of the next
four annual periods. We are obligated to make such guaranteed minimum payments in such first five
annual periods under the Agreement. Our obligation to make royalty payments will end on April 24,
2018, unless earlier terminated in accordance with the terms of the Agreement. In August 2004, we established a leasing facility with ePlus Group, Inc. with a total commitment of
$1,000,000. We intend to use such facility to fund the lease of computer hardware and associated
software. As of December 31, 2004, we have used approximately $304,000 of such commitment. 20




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##### 



We anticipate that working capital requirements will increase moderately for the foreseeable future
due to the investment necessary to support our European infrastructure and direct distribution
operations, as well as increasing accounts receivable as a result of expected revenue growth.
Prior to fiscal 2004 we had incurred negative cash flows from operations since our inception. We
have expended, and expect to continue to expend in the future, substantial funds to complete our
planned product development efforts, expand our sales and marketing activities and expand our
manufacturing capabilities. We expect that our existing capital resources will be adequate to fund
our operations through calendar year 2005. Our future capital requirements and the adequacy of
available funds may change, however, based on numerous factors, including our degree of success in
commercializing our products; our progress in product development efforts and the magnitude and
scope of such efforts; our success in increasing and maintaining customer relationships; our
ability to receive additional regulatory approvals for our product offerings; the cost and timing
of expansion of our manufacturing capabilities; the effectiveness of our sales and marketing
activities; the cost of filing, prosecuting, defending and enforcing patent claims and other
intellectual property rights; and competitive market developments. To the extent that our existing
capital resources and funds generated from operations are insufficient to meet current or planned
operating requirements, we will be required to obtain additional funds through equity or debt
financing, strategic alliances with corporate partners and others, or through other sources. Other
than our equipment leasing facility with ePlus Group, Inc., we do not have any committed sources of
additional financing, and there can be no assurance that additional funding, if necessary, will be
available on acceptable terms, if at all. If adequate funds are not available, we may be required
to delay, scale back or eliminate certain aspects of our operations or attempt to obtain funds
through arrangements with collaborative partners or others that may require us to relinquish rights
to certain of our technologies, product candidates, products or potential markets. Under such
conditions, our business, financial condition and results of operations will be materially
adversely affected. We have summarized below our material contractual obligations as of December 31, 2004 (in
thousands): Less Than
    
    
    One to
    
    
    Four to
    
    
    After FiveContractual Obligations
    
    Total
    
    
    One Year
    
    
    Three Years
    
    
    Five Years
    
    
    YearsLong-term debt
    
    $
    743,723
    
    
    $
    115,842
    
    
    $
    354,639
    
    
    $
    273,242
    
    
    $
    Physician detailing
agreement
    
    
    3,048,198
    
    
    
    3,048,198
    
    
    
    
    
    
    
    
    
    
    
    Operating leases
    
    
    41,027,125
    
    
    
    3,956,034
    
    
    
    13,063,037
    
    
    
    8,475,003
    
    
    
    15,533,051Minimum royalty payments
(1)
    
    
    16,500,000
    
    
    
    2,500,000
    
    
    
    10,500,000
    
    
    
    3,500,000
    
    
    
    Total contractual cash
obligations
    
    $
    61,319,046
    
    
    $
    9,620,074
    
    
    $
    23,917,676
    
    
    $
    12,248,245
    
    
    $
    15,533,051
   (1)
 21




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Item 3. Quantitative and Qualitative Disclosures about Market Risk We are subject to market risk associated with changes in foreign currency exchange rates and
interest rates. Our exchange rate risk comes from our operations in Europe and South America. In
the quarter ended December 31, 2004, foreign currency exchange rate fluctuations had an impact on
revenues from our operations outside the United States and impacted the amount of expenditures
recorded for international operations. The net impact of foreign exchange activities on earnings
was immaterial for the three- and six-month periods ended December 31, 2004 and 2003, respectively.
Interest rate exposure is primarily limited to the approximately $39,752,000 of cash, cash
equivalents and short-term investments owned by us. Such investments are money market debt
securities that generate interest income for us on cash balances. We do not actively manage the
risk of interest rate fluctuations; however, such risk is mitigated by the relatively short-term
nature of our investments. We do not consider the present rate of inflation to have a significant
impact on our business. Item 4. Controls and Procedures Our management, under the supervision and with the participation of the principal executive officer
and principal financial officer, have evaluated the effectiveness of our controls and procedures
related to our reporting and disclosure obligations as of December 31, 2004, which is the end of
the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the principal
executive officer and principal financial officer have concluded that these disclosure controls and
procedures are sufficient to provide that (a) material information relating to us, including our
consolidated subsidiaries, is made known to these officers by other employees of us and our
consolidated subsidiaries, particularly material information related to the period for which this
periodic report is being prepared; and (b) this information is recorded, processed, summarized,
evaluated and reported, as applicable, within the time periods specified in the rules and forms
promulgated and adopted by the Securities and Exchange Commission. There were no changes that occurred during the fiscal quarter covered by this Quarterly Report on
Form 10-Q that have materially affected, or are reasonable likely to materially affect, our
internal controls over financial reporting. 22




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PART II. Other Information Item 1. Legal Proceedings Pending Legal Proceedings: Digene Corporation v. Ventana Medical Systems, Inc. and Beckman Coulter, Inc. On November 19, 2001, we filed an action for patent infringement against Ventana Medical Systems,
Inc. The action was filed in the United States District Court for the District of Delaware. In
the action, we allege that Ventana Medical Systems, Inc. has made, used, sold and/or offered for
sale products embodying our patented inventions thereby infringing our United States Patent No.
4,849,332 entitled Human Papilloma Virus 35 Nucleic Acid Hybridization Probes and Methods for
Employing the Same and our United States Patent No. 4,849,331 entitled Human Papilloma Virus 44

Nucleic Acid Hybridization Probes and Methods for Employing the Same. We are seeking a permanent
injunction and monetary damages for past infringement. On September 25, 2002, Ventana Medical
Systems, Inc. publicly announced that it had acquired Beckman Coulter, Inc.s human papillomavirus
business and corresponding assets, including the assignment of the human papillomavirus
intellectual property portfolio acquired by Beckman Coulter, Inc. from Institut Pasteur through a
1991 sublicense agreement. On October 18, 2002, we filed a motion to amend our complaint to add
Beckman Coulter, Inc. as a co-defendant, as well as additional claims against Ventana. On December
10, 2002, the Court granted our motion to amend. On January 28, 2003, we filed a motion to file a
second amended complaint. On March 9, 2003 the Court granted our motion to amend. In the course of this litigation, Ventana and Beckman Coulter filed motions seeking to compel
arbitration of our claims against them. After a bench trial, the Court issued an order that
Beckman Coulter has a right to arbitrate our claims against it, but that Ventana does not. On
December 23, 2004, we submitted a demand for arbitration against Beckman with the American
Arbitration Association (AAA). No substantive actions have been taken by the AAA to date. The
Court, as a matter of judicial economy, has stayed the proceedings against Ventana pending the
outcome of the arbitration between us and Beckman Coulter. Georgetown University v. Digene Corporation Through a license agreement with Georgetown University, we obtained exclusive, worldwide rights to
United States Patent No. 5,643,715 and corresponding foreign patents and patent applications
relating to human papillomavirus (HPV) type 52, and to United States Patent No. 5,057,411 and
corresponding foreign patents relating to the use of the L1 gene sequence to detect specific human
papillomavirus types. Unless terminated earlier, the license agreement will terminate upon the
last to expire of the licensed patent rights. We are obligated to make royalty payments to
Georgetown University based on the percentage of net sales of products (as defined in the license
agreement). We continue to accrue and pay royalties to Georgetown University under the license
agreement. We had been involved in discussions with Georgetown University related to the
interpretation over the calculation of such royalties. The parties have not been able to resolve
the differences in their interpretations of the royalty calculation. 23




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On October 26, 2004, we received a copy of a complaint filed by Georgetown University in the United
States District Court for the District of Columbia, which was later served on November 22, 2004,
containing allegations related to the royalties dispute and our use of the licensed patent rights
under the license agreement. In its complaint, Georgetown University alleges that it is entitled
to royalties of 8% on net sales of products covered by the license agreement, that the total amount
of unpaid and past-due royalties owed by the Company to Georgetown University exceeds $2.0 million,
that the Companys license rights under the L1 Patent are terminated under the provisions of the
license agreement and that the Company is in breach of the license agreement for not using its best
efforts to develop products covered by the L1 Patent. We assert that we have complied fully with
the terms of our license agreement with Georgetown University. We believe that Georgetown
Universitys interpretation of the license agreement provisions related to the calculation of
royalties is not correct, and that the royalties, when calculated under the provisions of the
license agreement, are consistent with the Companys historical and previously agreed upon
calculation of royalties. Moreover, we dispute Georgetown Universitys claim that the rights as it
relates to the L1 Patent are terminated as we have complied with all obligations under the license
agreement. On January 18, 2005, we filed our answer to the complaint, along with counter claims against
Georgetown University stemming from Georgetown Universitys failure to meet certain legal and
fiduciary duties under the license agreement. We believe we have strong defenses and counterclaims
against each of the allegations made in the complaint and intend to vigorously defend against such
action, and to aggressively pursue our counterclaims against Georgetown University if a resolution
of this matter cannot be reached. Settled Legal Proceeding: Enzo Life Sciences v. Digene Corporation As we have previously disclosed in prior filings with the Securities and Exchange Commission, on
March 15, 2002, we filed an action for declaratory judgment against Enzo Biochem, Inc. The action
was filed in the United States District Court for the District of Delaware. We filed this action
after having received direct threats from Enzo Biochem, Inc. of infringement of U.S. Patent No.
6,221,581 entitled Processes for Detecting Polynucleotides, Determining Genetic Mutations or
Defects in Genetic Material, Separating or Isolating Nucleic Acid of Interest from Samples, and
Useful Compositions of Matter and Multihybrid Complex Compositions. We sought a judgment that the
patent is invalid and has not been infringed by us. On March 20, 2002, in response to our
complaint, Enzo Biochem, Inc. filed a motion to dismiss our complaint for lack of subject matter
jurisdiction, based on assertions that Enzo Life Sciences, Inc. (formerly Enzo Diagnostics, Inc.
and a wholly owned subsidiary of Enzo Biochem, Inc.), not Enzo Biochem, Inc., was the holder of the
patent in question. On the same day, Enzo Life Sciences, Inc. also filed a complaint for patent
infringement against us in the Delaware District Court. Enzo Life Sciences, Inc. asserted in its
complaint that we infringed U.S. Patent No. 6,221,581 through the manufacture, sale and offer for
sale of our Hybrid Capture products. The two cases were consolidated. On October 13, 2004, we settled the action with Enzo Biochem, Inc. and Enzo Life Sciences, Inc.
(collectively Enzo). Under the Settlement and License Agreement (the Agreement), we were
granted an irrevocable, non-exclusive, royalty-bearing license under Enzos U.S. Patent No.
6,221,581 and any and all other U.S. patents of Enzo that claim priority to any patent application
to which such patent claims the benefit of priority, and any non-U.S. counterparts. The parties
have provided mutual releases for all past claims in the Agreement. We also received releases and
covenants not to sue from Enzo under Enzos existing patent portfolio for all of our products
covered by the license grant, and covenants not to sue from Enzo for future licensed products
covered by the claims that also cover the existing licensed products. Under the Agreement, we paid Enzo $16 million on October 14, 2004, of which $2.0 million can be
used to offset future royalty payments under the terms of the Agreement, resulting in $14.0 million
in settlement 24




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expense, which was recorded in the first fiscal quarter of 2005. We will also pay Enzo royalties
on future net sales of products covered by the license grant, which royalties will be at least $2.5
million for the first annual period and at least $3.5 million for each of the next four annual
periods under the Agreement. We are obligated to make such guaranteed minimum payments in such
first five annual periods. Our obligation to make royalty payments will end on April 24, 2018,
unless earlier terminated in accordance with the terms of the Agreement. On October 15, 2004, the parties filed a Joint Stipulation and Order of Dismissal with Prejudice
with the U.S. District Court for the District of Delaware to dismiss with prejudice the litigation
between Digene and Enzo, including all claims arising out of the pleadings in this action, and all
actions that could have been raised, known or unknown, with respect to the accused products. 25




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Item 6. Exhibits Exhibit No.
    
    Description3.1
    
    Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to
Digenes Registration Statement on Form S-1 (File No. 333-02968)).3.2
    
    Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.2 to Digenes Annual Report
on Form 10-K for the year ended June 30, 1999).4.1
    
    Form of Common Stock Certificate (Incorporated by reference to Exhibit 4.1 to Digenes
Registration Statement on Form S-1 (File No. 333-02968)).31.1
    
    Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer31.2
    
    Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Financial Officer32
    
    Certification pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code.
 26




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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. DIGENE CORPORATIONDate: February 8, 2005
    By:
    /s/ Charles M. FleischmanCharles M. FleischmanPresident, Chief Operating Officer andChief Financial Officer(Principal Financial Officer)Date: February 8, 2005
    By:
    /s/ Joseph P. SlatteryJoseph P. SlatterySenior Vice President, Finance andInformation Systems(Principal Accounting Officer)
 27




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EXHIBIT INDEX Exhibit No.
    
    Description3.1
    
    Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to
Digenes Registration Statement on Form S-1 (File No. 333-02968)).3.2
    
    Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.2 to Digenes Annual Report
on Form 10-K for the year ended June 30, 1999).4.1
    
    Form of Common Stock Certificate (Incorporated by reference to Exhibit 4.1 to Digenes
Registration Statement on Form S-1 (File No. 333-02968)).31.1
    
    Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer.31.2
    
    Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Financial Officer.32
    
    Certification pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code.