##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One)[ü]
    
    Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the quarterly period ended June 30, 2004OR[ ]
    
    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 Commission File Number 0-21872 GEN-PROBE INCORPORATED  Delaware(State or other jurisdiction of
incorporation or organization)
    
    33-0044608(I.R.S. Employer
Identification Number)
 10210 Genetic Center Drive
San Diego, CA 92121
(Address of principal executive offices) (858) 410-8000
(Registrants telephone number, including area code) 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 the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes þ No o As of July 30, 2004, there were 49,604,009 shares of the registrants
common stock, par value $0.0001 per share, outstanding.    1




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GEN-PROBE INCORPORATED TABLE OF CONTENTS
FORM 10-Q PagePART IItem 1. Financial Statements
    
    
    
    3Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    
    10Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    
    33Item 4. Controls and Procedures
    
    
    
    33PART II
    
    
    
    34Item 1. Legal Proceedings
    
    
    
    34Item 4. Submission of Matters to a Vote of Security Holders
    
    
    
    34Item 6. Exhibits and Reports on Form 8-K
    
    
    
    34SIGNATURES
    
    
    
    37CERTIFICATIONSEXHIBIT 3.3Exhibit-3.4EXHIBIT 10.71EXHIBIT 10.72EXHIBIT 10.73EXHIBIT 10.74EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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Item 1. Financial Statements GEN-PROBE INCORPORATED CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) June 30,
    
    
    December 31,2004
    
    
    2003(unaudited)Current assets:Cash and cash equivalents
    
    $
    27,952
    
    
    $
    35,973Short-term investments
    
    
    164,841
    
    
    
    120,333Trade accounts receivable, net of allowance for doubtful accounts of $714
and $717 at June 30, 2004 and December 31, 2003, respectively
    
    
    17,827
    
    
    
    15,158Accounts receivable  other
    
    
    6,939
    
    
    
    2,555Inventories
    
    
    27,649
    
    
    
    15,096Deferred income taxes
    
    
    9,490
    
    
    
    10,979Prepaid expenses and other current assets
    
    
    11,480
    
    
    
    8,783Total current assets
    
    
    266,178
    
    
    
    208,877Property, plant and equipment, net
    
    
    67,063
    
    
    
    65,478Capitalized software, net
    
    
    24,723
    
    
    
    24,872Goodwill
    
    
    18,621
    
    
    
    18,621Other assets
    
    
    6,397
    
    
    
    6,893Total assets
    
    $
    382,982
    
    
    $
    324,741Current liabilities:Accounts payable
    
    
    10,825
    
    
    
    9,250Accrued salaries and employee benefits
    
    
    10,579
    
    
    
    11,670Other accrued expenses
    
    
    5,317
    
    
    
    6,085Income taxes payable
    
    
    14,218
    
    
    
    6,191Deferred revenue
    
    
    10,775
    
    
    
    6,681Total current liabilities
    
    
    51,714
    
    
    
    39,877Deferred income taxes
    
    
    6,926
    
    
    
    6,850Deferred revenue
    
    
    5,333
    
    
    
    5,667Deferred rent
    
    
    313
    
    
    
    323Minority interest
    
    
    2,013
    
    
    
    1,649Commitments and contingenciesStockholders equity:Preferred stock, $.0001 par value per share; 20,000,000 shares authorized, none issued and
outstanding
    
    
    
    
    
    
    Common stock, $.0001 par value per share; 200,000,000 shares authorized, 49,590,728 and
48,721,560 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively
    
    
    5
    
    
    
    5Additional paid-in capital
    
    
    228,019
    
    
    
    212,586Deferred compensation
    
    
    (1,283
    )
    
    
    (538
    )Accumulated other comprehensive income
    
    
    474
    
    
    
    343Retained earnings
    
    
    89,468
    
    
    
    57,979Total stockholders equity
    
    
    316,683
    
    
    
    270,375Total liabilities and stockholders equity
    
    $
    382,982
    
    
    $
    324,741
 See accompanying notes to consolidated financial statements. 3




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GEN-PROBE INCORPORATED CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2004
    
    
    2003
    
    
    2004
    
    
    2003Revenues:Product sales
    
    $
    52,600
    
    
    $
    46,299
    
    
    $
    107,630
    
    
    $
    89,919Collaborative research revenue
    
    
    7,007
    
    
    
    3,840
    
    
    
    13,738
    
    
    
    5,737Royalty and license revenue
    
    
    1,618
    
    
    
    543
    
    
    
    16,343
    
    
    
    1,194Total revenues
    
    
    61,225
    
    
    
    50,682
    
    
    
    137,711
    
    
    
    96,850Operating expenses:Cost of product sales
    
    
    13,164
    
    
    
    11,055
    
    
    
    27,028
    
    
    
    23,974Research and development
    
    
    15,896
    
    
    
    16,422
    
    
    
    34,315
    
    
    
    27,655Marketing and sales
    
    
    6,578
    
    
    
    5,892
    
    
    
    13,390
    
    
    
    10,547General and administrative
    
    
    7,476
    
    
    
    5,391
    
    
    
    14,759
    
    
    
    10,017Total operating expenses
    
    
    43,114
    
    
    
    38,760
    
    
    
    89,492
    
    
    
    72,193Income from operations
    
    
    18,111
    
    
    
    11,922
    
    
    
    48,219
    
    
    
    24,657Other income (expense):Minority interest
    
    
    (83)
    
    
    
    
    
    
    
    (179)
    
    
    
    Interest income
    
    
    186
    
    
    
    426
    
    
    
    1,026
    
    
    
    883Interest expense
    
    
    (4)
    
    
    
    (29)
    
    
    
    (13)
    
    
    
    (43)Other income (expense), net
    
    
    (78)
    
    
    
    59
    
    
    
    (136)
    
    
    
    66Total other income (expense)
    
    
    21
    
    
    
    456
    
    
    
    698
    
    
    
    906Income before income taxes
    
    
    18,132
    
    
    
    12,378
    
    
    
    48,917
    
    
    
    25,563Income tax expense
    
    
    6,371
    
    
    
    4,229
    
    
    
    17,428
    
    
    
    8,760Net income
    
    $
    11,761
    
    
    $
    8,149
    
    
    $
    31,489
    
    
    $
    16,803Net income
per share(1):Basic
    
    $
    0.24
    
    
    $
    0.17
    
    
    $
    0.64
    
    
    $
    0.35Diluted
    
    $
    0.23
    
    
    $
    0.17
    
    
    $
    0.62
    
    
    $
    0.35Weighted
average shares outstanding(1):Basic
    
    
    49,302
    
    
    
    47,650
    
    
    
    49,103
    
    
    
    47,624Diluted
    
    
    51,402
    
    
    
    48,466
    
    
    
    51,200
    
    
    
    48,059
   (1) All share and per share amounts reflect the 2-for-1 stock split
implemented as a 100% stock dividend in September 2003. See accompanying notes to consolidated financial statements. 4




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GEN-PROBE INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Six Months EndedJune 30,2004
    
    
    2003Operating activitiesNet income
    
    $
    31,489
    
    
    $
    16,803Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
    
    
    8,361
    
    
    
    7,922Stock compensation charges
    
    
    199
    
    
    
    Loss on disposal of property and equipment
    
    
    27
    
    
    
    58Deferred rent
    
    
    (10)
    
    
    
    1Stock option income tax benefits
    
    
    2,220
    
    
    
    Deferred revenue
    
    
    3,760
    
    
    
    1,789Deferred income taxes
    
    
    1,662
    
    
    
    153Minority interest
    
    
    249
    
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    (6,460)
    
    
    
    (2,423)Inventories
    
    
    (12,546)
    
    
    
    (39)Prepaid expenses and other current assets
    
    
    (2,696)
    
    
    
    (2,244)Accounts payable
    
    
    1,565
    
    
    
    (989)Accrued salaries and employee benefits
    
    
    (1,091)
    
    
    
    (740)Other accrued expenses
    
    
    (1,412)
    
    
    
    (71)Income taxes payable
    
    
    8,066
    
    
    
    (1,597)Net cash provided by operating activities
    
    
    33,383
    
    
    
    18,623Investing activitiesProceeds from sales and maturities of short-term investments
    
    
    108,958
    
    
    
    22,729Purchases of short-term investments
    
    
    (153,173)
    
    
    
    (40,663)Purchases of property, plant and equipment
    
    
    (8,824)
    
    
    
    (6,143)Capitalization of software development costs
    
    
    (270)
    
    
    
    (983)Capitalization of patent costs
    
    
    (284)
    
    
    
    (298)Other assets
    
    
    (394)
    
    
    
    (90)Net cash used in investing activities
    
    
    (53,987)
    
    
    
    (25,448)Financing activitiesProceeds from issuance of common stock
    
    
    12,269
    
    
    
    1,964Net cash provided by financing activities
    
    
    12,269
    
    
    
    1,964Effect of exchange rate changes on cash
    
    
    314
    
    
    
    Net increase (decrease) in cash and cash equivalents
    
    
    (8,021)
    
    
    
    (4,861)Cash and cash equivalents at the beginning of the period
    
    
    35,973
    
    
    
    43,118Cash and cash equivalents at the end of the period
    
    
    27,952
    
    
    
    38,257Supplemental disclosure of cash flow information:Cash paid (received) for:Interest
    
    $
    9
    
    
    $
    37Income taxes
    
    $
    6,587
    
    
    $
    10,241
 See accompanying notes to consolidated financial statements. 5




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Notes to the Consolidated Financial Statements (unaudited) Note 1  Basis of presentation The accompanying interim consolidated financial statements of Gen-Probe
Incorporated (Gen-Probe or the Company) at June 30, 2004, and for the three
and six month periods ended June 30, 2004 and 2003, are unaudited and have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. In managements
opinion, the unaudited financial statements include all adjustments, consisting
only of normal recurring accruals, necessary to state fairly the financial
information therein, in accordance with generally accepted accounting
principles. Interim results are not necessarily indicative of the results which
may be reported for any other interim period or for the year ending December
31, 2004. These unaudited consolidated financial statements and footnotes thereto
should be read in conjunction with the audited financial statements and
footnotes thereto contained in the Companys Annual Report on Form 10-K for the
year ended December 31, 2003. Note 2  Reporting periods The Company operates and reports on fiscal periods ending on the Friday
closest to the end of the month except for year-end, which closes December 31.
For ease of presentation, the quarterly reporting periods are deemed to end on
March 31, June 30 and September 30. The three months ended March 31, 2004 and
six months ended June 30, 2004 included three more business days compared to
the same periods in the prior year. Note 3  Summary of significant accounting policies Principles of consolidation The consolidated financial statements of the Company include the accounts
of the Company and its subsidiaries, Gen-Probe Sales and Services, Inc.,
Gen-Probe Canada, Inc., Gen-Probe UK Limited and Molecular Light Technology
Limited and its subsidiaries. All intercompany transactions and balances have
been eliminated in consolidation. 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. These estimates include assessing the collectibility of
accounts receivable and the valuation of inventories and long-lived assets.
Actual results could differ from those estimates. Foreign currency translation The functional currency of the Companys majority owned subsidiary,
Molecular Light Technology Limited and its subsidiaries, is the British pound.
Accordingly, all balance sheet accounts of this subsidiary are translated into
United States dollars using the exchange rate in effect at the balance sheet
date, and revenues and expenses are translated using the average exchange rates
in effect during the period. The gains and losses from foreign currency
translation of this subsidiarys financial statements are recorded directly as
a separate component of stockholders equity under the caption Accumulated
other comprehensive income. Reclassifications Certain prior year amounts have been reclassified to conform with the
current year presentation. Note 4  Stock-based compensation In June 2004, the Company granted 20,000 shares of restricted common stock
to its chief executive officer under the 2003 Incentive Award Plan of Gen-Probe
Incorporated (the 2003 Plan), resulting in deferred compensation of $839,000
associated with this grant. The deferred compensation is being amortized to
expense over the vesting period of the restricted stock. 6




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The Company measures compensation expense for its employee stock-based
compensation using the intrinsic value method and provides pro forma
disclosures of net income and earnings per common share as if the fair value
methods had been applied in measuring compensation expense. Under the intrinsic
value method, compensation cost for employee stock awards is recognized as the
excess, if any, of the deemed fair value for financial reporting purposes of
the Companys common stock on the date of grant over the amount an employee
must pay to acquire the stock. Pro forma information regarding net income is required to be disclosed in
interim financial statements by Statement of Accounting Standards (SFAS) No.
148, and has been determined as if the Company had accounted for its employee
stock options and employee stock purchase plan under the fair value method of
SFAS No. 123. The fair value for employee stock options was estimated at the
dates of grant using the minimum value option pricing model from the stock
option plan inception date in 2000 through September 15, 2002 and the
Black-Scholes pricing model for all option grants made subsequent to that date.
The following weighted average assumptions were used: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Risk free interest rate
    
    
    3.60
    %
    
    
    2.27
    %
    
    
    3.19
    %
    
    
    2.38
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Volatility factor
    
    
    64
    %
    
    
    50
    %
    
    
    66
    %
    
    
    50
    %Expected life (in years)
    
    
    4
    
    
    
    4
    
    
    
    4
    
    
    
    4Resulting average fair value
    
    $
    20.68
    
    
    $
    6.70
    
    
    $
    18.64
    
    
    $
    6.24
 The fair value of each purchase right issued under the Companys Employee
Stock Purchase Plan (ESPP) for the three and six month periods ended June 30,
2004 and 2003 was estimated on the date of grant using the Black-Scholes
pricing model. The following weighted average assumptions were used: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Risk free interest rate
    
    
    1.0
    %
    
    
    1.0
    %
    
    
    1.0
    %
    
    
    1.0
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Volatility factor
    
    
    66
    %
    
    
    54
    %
    
    
    59
    %
    
    
    54
    %Expected life (in years)
    
    
    .50
    
    
    
    .20
    
    
    
    .50
    
    
    
    .20Resulting average fair value
    
    $
    6.33
    
    
    $
    1.80
    
    
    $
    5.46
    
    
    $
    1.80
 Had compensation expense for stock-based compensation plans been
determined based on the fair value method prescribed under SFAS No. 123, the
Companys net income and net income per share would have been as follows (in
thousands, except per share data): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income:As reported
    
    $
    11,761

    
    $
    8,149

    
    $
    31,489

    
    $
    16,803Stock-based employee compensation expense included in reported net
income, net of related tax effects
    
    
    33

    
    
    

    
    
    55

    
    
    Total stock based employee compensation
expense determined under
fair value based method for all awards, net of related tax effects
    
    
    (2,397)

    
    
    (234)

    
    
    (4,289)

    
    
    (418)Pro forma net income
    
    $
    9,397

    
    $
    7,915

    
    $
    27,255

    
    $
    16,385Net income per share:As reportedBasic
    
    $
    0.24

    
    $
    0.17

    
    $
    0.64

    
    $
    0.35Diluted
    
    $
    0.23

    
    $
    0.17

    
    $
    0.62

    
    $
    0.35Pro
formaBasic
    
    $
    0.19

    
    $
    0.17

    
    $
    0.56

    
    $
    0.34Diluted
    
    $
    0.18

    
    $
    0.16

    
    $
    0.53

    
    $
    0.34
 7




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The pro forma effects on net income for the three and six month periods
ended June 30, 2004 and 2003 are not likely to be representative of the effects
on reported net income in future years. In managements opinion, existing stock
option valuation models do not provide a reliable single measure of the fair
value of employee stock options that have vesting provisions and are not
transferable. In addition, option valuation models require the input of highly
subjective assumptions, and changes in such subjective assumptions can
materially affect the fair value estimate of employee stock options. Note 5  Net income per share The Company computes net income per share in accordance with SFAS No. 128,
Earnings Per Share, and SEC Staff Accounting Bulletin (SAB) No. 98. Basic
net income per share is computed based on the weighted average number of common
shares outstanding during the period. Diluted net income per share is computed
based on the weighted average number of shares of common stock and other
dilutive securities outstanding during the period. Under the provisions of SAB
No. 98, common shares issued for nominal consideration, if any, would be
included in the per share calculations as if they were outstanding for all
periods presented. The following table sets forth the computation of net income per share (in
thousands, except per share amounts): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    11,761

    
    $
    8,149

    
    $
    31,489

    
    $
    16,803Weighted average shares outstanding  Basic
    
    
    49,302

    
    
    47,650

    
    
    49,103

    
    
    47,624Effect of dilutive common stock options
outstanding
    
    
    2,100

    
    
    816

    
    
    2,097

    
    
    435Weighted average shares outstanding  Diluted
    
    
    51,402

    
    
    48,466

    
    
    51,200

    
    
    48,059Net income per share:Basic
    
    $
    0.24

    
    $
    0.17

    
    $
    0.64

    
    $
    0.35Diluted
    
    $
    0.23

    
    $
    0.17

    
    $
    0.62

    
    $
    0.35
 Dilutive securities include common stock options subject to vesting and
unvested restricted stock. Potentially dilutive securities totaling 225,636 and
135,564 for the three months ended June 30, 2004 and 2003, and 307,086 and
179,200 shares for the six months ended June 30, 2004 and 2003, respectively,
were excluded from the calculation of diluted earnings per share because of
their anti-dilutive effect. Note 6  Comprehensive income Comprehensive income is comprised of net income and other comprehensive
income (loss), which includes certain changes in stockholders equity such as
foreign currency translation of our majority owned subsidiarys financial
statements and unrealized gains and losses on our available for sale
securities. Components of comprehensive income, net of income taxes, were as follows
(in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    11,761

    
    $
    8,149
    

    $
    31,489
    

    $
    16,803Foreign currency translation adjustment
    
    
    (412)

    
    
    

    
    
    504

    
    
    Change in unrealized gain (loss) on investments
    
    
    (196)

    
    
    150

    
    
    (373)

    
    
    206Comprehensive income
    
    $
    11,153

    
    $
    8,299

    
    $
    31,620

    
    $
    17,009
 8




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Note 7  Inventories Net inventories are comprised of the following (in thousands): June 30,
    

    December 31,2004
    

    2003Raw materials
    
    $
    7,540

    
    $
    5,874Work in progress
    
    
    6,569

    
    
    3,118Finished goods
    
    
    13,540

    
    
    6,104$
    27,649

    
    $
    15,096
 Note 8  Stockholders equity Number of authorized shares of common stock On September 5, 2003, the Companys Board of Directors authorized a
two-for-one stock split implemented as a 100% stock dividend, effective
September 30, 2003 for holders of record as of September 16, 2003 (the Stock
Split). As a result of the Stock Split by stock dividend, the number of
outstanding shares of the Companys common stock and the number of shares of
the Companys common stock reserved under its equity compensation plans was doubled. On May 28, 2004, the
Companys stockholders approved an increase in the authorized number of shares
of common stock under the Companys Certificate of Incorporation from 100,000,000 to 200,000,000 shares. Common stock During the three and six months ended June 30, 2004, 514,118 and 809,647
options, respectively to purchase shares of the Companys common stock were exercised by
Gen-Probe employees at a weighted average exercise price of $13.42 and $13.22,
respectively. The Company also issued 719 and 2,804 shares of restricted common
stock at fair market value during the three and six months ended June 30, 2004, respectively to members of the Board of Directors as partial consideration for services
rendered, resulting in an expense totaling $34,023 and $106,535, respectively,
which was equal to the fair market value on the date of grants. Further,
employees purchased 56,717 shares of the Companys common stock at an average
purchase price of $26.92 per share during the six months ended June 30, 2004,
pursuant to the Companys ESPP. Note 9  Litigation The Company is a party to the following litigation and is currently
participating in other litigation in the ordinary course of business. The
Company intends to vigorously defend its interests in these matters. The
Company expects that the resolution of these matters will not have a material
adverse effect on its business, financial condition or results of operations.
However, due to the uncertainties inherent in litigation, no assurance can be
given as to the outcome of these proceedings. If any of these matters were
resolved in a manner unfavorable to the Company, its business, financial
condition and results of operations would be harmed. Enzo Biochem, Inc. In June 1999, the Company was sued by Enzo Biochem, Inc. in the United
States District Court for the Southern District of New York. Enzo alleged that
the Company and its former affiliates, as well as Becton Dickinson and
bioMérieux, have willfully infringed United States patent no. 4,900,659, or the
 659 patent, through the manufacture and sale of products for the diagnosis
of gonorrhea. The Companys former affiliates and bioMérieux have been
dismissed from the case by Enzo. The Company and Becton Dickinson remain as
defendants. Enzo asserted a damage claim based on a contention that Enzo was
entitled to a reasonable royalty on all sales of Gen-Probe products for the
detection of Neisseria gonorrhoeaebacteria from June 1993 through trial.
Revenues from tests for the detection of Neisseria gonorrhoeaehave constituted
a significant portion of Gen-Probes revenues during the relevant period. The
Company believes that the claims of the 659 patent are invalid, unenforceable
and may not be properly interpreted to cover its products. On July 27, 2004,
the Court granted summary judgment in favor of the defendants and against Enzo,
holding that the 659 patent is invalid based on an on-sale doctrine. Enzo has
indicated that it plans to appeal the summary judgment to the United States
Court of 9




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Appeals for the Federal Circuit. The Company intends to vigorously defend
the lawsuit. However, there can be no assurance that the case will be resolved
in the Companys favor. Vysis, Inc. In December 1999, the Company initiated litigation in the United States
District Court for the Southern District of California against Vysis, now a
subsidiary of Abbott Laboratories, seeking a declaratory judgment that the
Companys products were not covered by a Vysis patent that is the subject of a
license granted by Vysis in favor of the Company and that the patent is invalid
and unenforceable. In August 2002, following a jury trial, the District Court
entered judgment in the Companys favor, finding the Vysis patent invalid and
finding that the patent does not cover Gen-Probes products. On September 3,
2002, Vysis filed a notice of appeal with the District Court. Further, on
October 22, 2002 while Vysis appeal was pending, the United States Patent &
Trademark Office reissued the Vysis patent with amended claims. On October 22,
2002, the Company filed a second lawsuit in District Court to challenge the
validity and scope of the reissued patent. On March 5, 2004, the Court of
Appeals vacated the District Courts August 2002 judgement in favor of the
Company and directed the District Court to dismiss the case on the ground of
lack of subject matter jurisdiction. The Companys petition for rehearing and
rehearing en banc (with the participation of all the judges) was denied by the
Federal Circuit. In accordance with the denial, on July 14,
2004, the District Court dismissed the action with prejudice. The Company intends to file a petition for review by the
United States Supreme Court of the lower courts decision. There can be no
assurances as to the final outcome of this litigation. The Company has at all
times maintained the license with Vysis in full force and continued to make
royalty payments under the license, pending final resolution of the litigation. Bayer Corporation In November 2002, the Company filed a demand for arbitration against Bayer
Corporation, or Bayer, in the Judicial Arbitration & Mediation Services, Inc.,
or JAMS, office in San Diego, California related to the Companys collaboration
with Bayer for nucleic acid diagnostic tests for viral organisms. Under the
terms of the collaboration agreement, Bayer acquired the exclusive right to
distribute nucleic acid diagnostic tests designed and developed by Gen-Probe
for the detection of HIV, hepatitis viruses and other specified viruses,
subject to certain conditions. Gen-Probes demand for arbitration states that
Bayer has failed to fulfill the conditions required to maintain exclusive
distribution rights. The arbitration demand seeks confirmation that the
agreement grants Gen-Probe, in the present circumstances, a co-exclusive right
to directly distribute the viral diagnostic tests that are the subject of the
agreement. Gen-Probes arbitration demand also seeks money damages due to
Bayers failure to use commercially reasonable efforts to promote, market and
sell viral diagnostic assays developed by Gen-Probe. In November 2003, Bayer
filed a counterclaim for money damages based on alleged delays in the
development of the TIGRIS system, alleged delays in the development of certain
assays, and other claims. Bayer Healthcare LLC has also been added as a
respondent and counterclaimant. The matter has been set for hearing beginning
September 13, 2004. There can be no assurances as to the final outcome of the
arbitration. On March 17, 2004, the Company filed a patent infringement action in the
United States District Court for the Southern District of California against
Bayer Corporation and Bayer Healthcare LLC, alleging that Bayers bDNA nucleic
acid tests for HIV and HCV infringe Gen-Probes U.S. patent no. 5,955,261,
entitled Method for Detecting the Presence of Group-Specific Viral mRNA in a
Sample. Bayers bDNA tests are not covered by the collaboration agreement
between the companies. Bayer has denied the allegations of infringement and
alleged that the patent is invalid or unenforceable. No trial date has been
set. There can be no assurances as to the final outcome of the litigation. Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations This report contains forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995, which provides a safe
harbor for these types of statements. To the extent statements in this report
involve, without limitation, our expectations for growth, estimates of future
revenue, expenses, profit, cash flow, balance sheet items or any other guidance
on future periods, these statements are forward-looking statements.
Forward-looking statements are not guarantees of performance. They involve
known and unknown risks, uncertainties and assumptions that may cause actual
results, levels of activity, performance or achievements to differ materially
from any results, level of activity, performance or achievements expressed or
implied by any forward-looking statement. We assume no obligation to update any
forward-looking statements. The following information should be read in conjunction with our June 30,
2004 consolidated financial statements and related notes thereto and with our
consolidated financial statements and notes thereto for the year ended December
31, 2003 and the related Managements Discussion and Analysis of Financial
Condition and Results of Operations contained in our Annual Report on Form
10-K for the year ended December 31, 2003. We also urge you to review and
consider our disclosures describing various risks that may affect our business,
which are set forth under the heading Risk Factors in this report and in our
Annual Report on Form 10-K for the 10




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year ended December 31, 2003. Overview We are a global leader in the development, manufacture and marketing of
rapid, accurate and cost-effective nucleic acid probe-based products used for
the clinical diagnosis of human diseases and for the screening of donated human
blood. We have over 21 years of nucleic acid detection research and product
development experience, and our products, which are based on our patented
nucleic acid testing, or NAT, technology, are used daily in clinical
laboratories and blood collection centers in major countries throughout the
world. In September 2002, our common stock began trading on the Nasdaq National
Market immediately after our former parent company, Chugai Pharmaceutical Co.,
Ltd. distributed all of its shares of our common stock to its shareholders.
Since our spin-off into an independent, publicly traded company, we have
achieved strong growth in both revenues and earnings due principally to the
success of our blood screening products which are used to detect the presence
of human immunodeficiency virus (type 1), or HIV-1, and hepatitis C virus, or
HCV. Under our collaboration agreement with Chiron Corporation, or Chiron, we
are responsible for the research, development, regulatory process and
manufacturing of our blood screening products, while Chiron is responsible for
marketing, sales, distribution and service. During the three and six months ended June 30, 2004, we achieved strong
financial results. Net income for the six month period ended June 30, 2004 was
$31.5 million ($0.62 per diluted share), compared to $16.8 million ($0.35 per
diluted share) in the same period of the prior year, an increase of 77% per
diluted share. Total revenues for the six month period ended June 30, 2004 were
$137.7 million, compared to $96.9 million in the same period of the prior year,
an increase of 42%. Product sales for the period ended June 30, 2004 were
$107.6 million, compared to $89.9 million in the same period of the prior year,
an increase of 20%. During the six month period ended June 30, 2004, net income
and total revenues included a contract milestone with Chiron and a license fee
earned in connection with our cross-licensing agreement with Tosoh Corporation,
or Tosoh. These amounts added approximately $0.17 to diluted earnings per share
and $13.5 million to revenues. Recent Events The launch of the Tigris system was slower than expected early in the
year, but picked up speed in the second quarter. Between assay revenues and
instrument sales, we remain on track to achieve $5 million or more in
TIGRIS-related revenue this year. Clinical trials of the Procleix Ultrio blood screening assay on both the
semi-automated and TIGRIS systems have been completed on schedule. Gen-Probe
remains on track to file a Biologics License Application (BLA) for the assay in
the third quarter of 2004. The pivotal clinical trial of the Procleix WNV assay began on schedule in
July 2004, and we remain on track to file a BLA for the assay in the first quarter
of 2005. So far this mosquito season, the assay has intercepted 42 confirmed
West Nile virus, or WNV, infected blood donations in nine states through ongoing screening
under an Investigational New Drug, or IND. In addition, Gen-Probe expects to begin IND testing of the
Procleix WNV assay on the fully automated TIGRIS system in August. We successfully completed the process of transferring DiagnoCures
first-generation assay for prostate cancer detection onto our APTIMA technology
platform, and development work is proceeding well. We have completed clinical trials to evaluate APTIMA Combo 2 to test for
Chlamydia trachomatis and Neisseria gonorrhoeae from
both Cytyc Corporations and TriPath Imaging Inc.s liquid Pap transport media. The Pap
test remains the most widely used screening test in the United States for the
early detection of cervical cancer. Approximately 50 million Pap tests are
performed annually in the United States, 80% of which are liquid-based.
Testing for Chlamydia trachomatis and Neisseria gonorrhoeae from the liquid Pap medium would offer patients,
physicians and laboratories convenient testing for several diseases from one
sample, and further differentiate the superior performance of APTIMA Combo 2 in
the widest range of specimen types. We intend to file for United States
regulatory clearance later this year. In December 2003, we signed a cross-licensing agreement with Tosoh,
effective January 1, 2004, for certain NAT technologies in clinical diagnostics
and other related fields. Under the agreement, we earned a $7.0 million
license fee during the three months ended March 31, 2004. In January 2004, we began United States clinical trials of the Procleix
Ultrio assay on the fully automated, high-throughput TIGRIS instrument system,
triggering a $6.5 million contract milestone payment from Chiron that we
recognized during the three months ended March 31, 2004. During January 2004,
the Procleix Ultrio assay, running on our semi-automated instrument system,
received its 11




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Community European, or CE, mark, which permitted Chiron to launch the
product in the European Economic Area. Revenues We derive revenues from three primary sources: product sales,
collaborative research revenue and royalty and license revenue. The majority of
our revenues come from product sales, which consist primarily of sales of our
NAT assays tested on the proprietary instruments that serve as the analytical
platform for our assays. We recognize as collaborative research revenue
payments we receive from Chiron for the products we provided under our
collaboration agreements with Chiron prior to their regulatory approval and the
payments we receive from Chiron, Bayer Corporation, or Bayer, and other
collaboration partners, including the National Institutes of Health, or NIH,
for research and development activities. Our royalty and license revenues
reflect fees paid to us by third parties for the use of our proprietary
technology. For the six months ended June 30, 2004, product sales,
collaborative research revenues, and royalty and license revenues equaled 78%,
10% and 12%, respectively, of our total revenues of $137.7 million. For the
same period in the prior year, product sales, collaborative research revenues,
and royalty and license revenues, equaled 93%, 6% and 1%, respectively, of our
total revenues of $96.9 million. Product sales Our primary source of revenue is the sale of clinical diagnostic products
in the United States, which include our APTIMA Combo 2, PACE 2, AccuProbe and
Amplified Mycobacterium Tuberculosis Direct Test product lines. During the six
months ended June 30, 2004, we shipped approximately 10.8 million tests for the
diagnosis of a wide variety of infectious microorganisms, including those
causing sexually transmitted diseases, or STDs, tuberculosis, strep throat,
pneumonia and fungal infections. The principal customers for our clinical
diagnostics products include large reference laboratories, public health
laboratories and hospitals located in North America, Europe and Japan. Since 1999, we have supplied NAT assays for use in screening blood
donations intended for transfusion. Our first blood screening assay detects
HIV-1 and HCV in donated human blood. Our blood screening assays and
instruments are marketed through our collaboration with Chiron under the
Procleix and Ultrio trademarks. We recognize product sales from the manufacture
and shipment of tests for screening donated blood, through our collaboration
with Chiron, to blood bank facilities located in the countries where our
products have obtained governmental approvals at a contractual transfer price.
Blood screening product sales are then adjusted monthly corresponding to
Chirons payment to us of amounts reflecting our ultimate share of net revenue
from sales by Chiron to the end user, less the transfer price revenues
previously recorded. Net sales are ultimately equal to the sales of the assays
by Chiron to third-parties, less freight, duty and certain other adjustments
specified in our agreement with Chiron, multiplied by our share of the net
revenue, which was 43.0% with respect to sales of assays that include a test
for HCV beginning the second quarter of 2002 upon implementation of commercial
pricing, through April 6, 2003, after which our share of net revenues from
sales of assays that include a test for HCV was adjusted to 47.5%. Effective
January 1, 2004, our share of net revenues from commercial sales of assays that
include a test for HCV was permanently changed to 45.75% under our agreement
with Chiron. With respect to commercial sales of blood screening assays under
our collaboration with Chiron that do not include a test for HCV, such as
possible future commercial tests for WNV, we will continue
to receive reimbursement for our manufacturing costs plus 50% of net revenues.
Our costs related to these products primarily include manufacturing costs. Collaborative research revenue We have developed a NAT assay to detect HIV-1 and HCV in donated human
blood and have also developed a semi-automated instrument system to conduct the
test. These assays and instruments are marketed through our collaboration with
Chiron under the Procleix name. In February 2002, the Food and Drug
Administration, or FDA, approved the Procleix HIV-1/HCV assays. In March 2003, we signed a definitive agreement with Chiron for the
development and commercialization of the Procleix Ultrio assay. For the six
month periods ended June 30, 2004 and 2003, we recognized $1.3 million and $2.8
million, respectively in reimbursements for expenses incurred related to the development of
this assay. In January 2004, we commenced clinical trials of the Procleix
Ultrio assay in the United States on our TIGRIS instrument. We have also
developed a NAT assay to detect WNV, which is currently being used in clinical
trials under an IND application. We expect to
receive further reimbursement for certain costs incurred during the development
of the Procleix Ultrio and WNV assays from Chiron and separately from the
National Heart, Lung, and Blood Institute, a part of the NIH. We have recorded revenues related to use of our blood screening products
in the United States and other countries in which the 12




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products have not received regulatory approval as collaborative research
revenue, because price restrictions applied to these products prior to FDA
license approval in the United States and similar approvals in foreign
countries. For the six months ended June 30, 2004, we recognized $9.2 million
in collaborative research revenue through our collaboration with Chiron from
deliveries of WNV tests on a cost recovery basis. We expect to continue
recognizing these sales as collaborative research revenue until FDA approval
has been received, although there is no guarantee we ultimately will receive
FDA approval. Since 1996, we have been awarded contracts aggregating approximately $28.2
million by the NIH to develop NAT assays for screening donated blood for HIV-1,
HCV, hepatitis B virus, or HBV, and WNV. To date, all payments due to us under
these reimbursement contracts have been received and have been recorded as
collaborative research revenues as reimbursable costs were incurred. As of June
30, 2004, the Company had approximately $0.2 million in reimbursements
remaining under this contract, which will be recognized during the third
quarter of 2004 as expenses are incurred. We recognize collaborative research revenue over the term of our strategic
alliance agreement with Chiron as reimbursable costs are incurred. The costs
associated with the reported collaborative research revenue are reflected in
our statements of income under the captions Research and development,
Marketing and sales and General and administrative, based on the nature of
the costs. We do not separately track the costs applicable to the blood
screening development collaboration with Chiron and, therefore, are not able to
quantify the direct costs associated with the collaborative research revenue. Collaborative research revenue tends to fluctuate based on the amount of
research services performed, delivery of assays on a cost recovery basis and
the status of projects under collaboration. Due to the nature of our
collaborative research revenues, results in any one period are not necessarily
indicative of results to be achieved in the future. Our ability to generate
additional collaborative research revenues depends, in part, on our ability to
initiate, maintain and perform under relationships with potential and current
collaborative partners. These relationships may not be established or
maintained and current collaborative research revenue may decline. Royalty and license revenue We recognize non-refundable up-front license fees over the performance
period of the applicable agreement or at the time that we have satisfied all
substantive performance obligations under such agreement. We also receive
milestone payments for successful achievement of contractual development
activities. Milestone payments are recognized as revenue upon achievement of
the milestone only if there are no remaining substantive performance
obligations under such agreement and the amounts are non-refundable. In December 2003, we entered into an agreement with Tosoh to cross-license
intellectual property covering certain NAT technologies. The licenses, which
were effective January 1, 2004, cover products in clinical diagnostics and
other related fields. Under the agreement, Tosoh received non-exclusive rights
to our proprietary Transcription-Mediated Amplification, or TMA, and rRNA
technologies in exchange for two payments totaling $7.0 million, which was
recognized as revenue in the first quarter of 2004. Additionally, Tosoh will
pay us royalties on worldwide sales of any future products that employ our
technologies licensed by Tosoh. We will gain access, in exchange for the
payment of royalties, to Tosohs patented Transcription Reverse-Transcription
Concerted, or TRC, amplification and Intercalation Activating Fluorescence, or
INAF, detection technologies for use with our real time TMA technology. Under the strategic alliance agreement we entered into with Chiron in June
1998, we have responsibility for research, development and manufacturing of the
blood screening products covered by the agreement, while Chiron has
responsibility for marketing, distribution and service of the blood screening
products worldwide. During the first quarter of 2004, the Company recognized as
royalty and license revenue, a $6.5 million milestone payment, as the Company
began clinical trial tests of the Procleix Ultrio assay on the TIGRIS
instrument in the United States. Additional payments of up to $10.0 million are
due to us in the future under the agreement if we achieve certain other
specified milestones relating to the development of the TIGRIS instrument.
There is no guarantee we will receive any additional milestone payments under
this agreement. Royalty and license revenue may fluctuate in the future based on the
nature of the related agreements and the timing of receipt of license fees and
achievement of research and development milestones. Results in any one period
are not necessarily indicative of results to be achieved in the future. In
addition, our ability to generate additional royalty and license revenues will
depend, in part, on our ability to market and capitalize on our technologies.
We may not be able to continue to do so in the future and future royalty and
license revenue may decline. Cost of product sales Cost of product sales includes direct material, direct labor, and
manufacturing overhead associated with the production of inventory 13




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on a standard cost basis. Indirect cost elements, which include
manufacturing variances, purchase price variances, and allowances for scrap,
etc., are also included as a component of cost of product sales, as well as
certain related expenses, such as royalties, warranty, and instrument
amortization. In addition, we manufacture significant quantities of raw materials,
development lots, and clinical trial lots of product prior to receiving FDA
approval for commercial sale. During the six month periods ended June 30, 2004
and 2003, our manufacturing facilities produced development lots for WNV and
Procleix Ultrio assays. The majority of the costs associated with these
development lots are classified as research and development expense. The
portion of a development lot that is manufactured to support In-Vitro
Diagnostic, or IVD, sales abroad is capitalized and classified as cost of sales
upon shipment. Our blood screening manufacturing facility has operated below its capacity
and will continue to operate below its capacity for the foreseeable future. A
portion of this available capacity has been utilized for research and
development activities, as new product offerings are identified for
commercialization. As a result certain operating costs of our blood screening
facility, together with other manufacturing costs for the production of
pre-commercial development lot assays that are delivered under the terms of an
IND application, are classified as research and development expense prior to
FDA approval. Effective January 1, 2004, our revenue sharing percentage with Chiron was
decreased, from 47.5% to 45.75%. This change, combined with higher instrument
costs, including the amortization of our capitalized software development costs
(which we began to amortize in the second quarter of 2004) and related service
costs attributed to the planned general commercial launch of our TIGRIS
instrument, may result in lower future gross margin percentage levels. In
addition, our non-military customers currently utilize pooled blood screening
samples for testing. We anticipate that requirements for smaller pool sizes or
ultimately individual donor testing, if and when implemented, could result in
lower gross margin rates, as additional tests would be required to deliver the
sample results, unless a corresponding increase in sales pricing is
implemented. We are not able to accurately predict the extent to which our
gross margin may be affected as a result of smaller pool sizes or individual
donor testing because we do not know the ultimate selling price that Chiron,
our distributor, would charge to the end user if smaller pool sizes or
individual donor testing is implemented. Research and development We invest significantly in research and development as part of our ongoing
efforts to accelerate the development of new products and technologies,
particularly our TIGRIS instrument and our Procleix Ultrio and WNV assays for
screening donated blood. Our research and development expenses consist of
expenses associated with the development of proprietary products and instrument
platforms, as well as expenses related to the co-development of new products
and technologies in collaboration with our strategic partners. Research and
development costs in total are expected to increase in the future due to new
product development, clinical trial costs and clinical manufacturing costs;
however, we expect our research and development expenses as a percentage of
total revenues to decline in future years. The timing of clinical trials and
development manufacturing costs is variable and is affected by product
development activities and the regulatory process. In connection with our research and development efforts, we have various
license agreements, which provide us with rights to develop and market products
using certain technologies and patent rights maintained by third parties. These
agreements generally provide for a term that commences upon execution of the
agreement and continues until expiration of the last patent related to the
technologies covered by the license. Research and development costs include the costs of raw materials,
development lots and clinical trial lots of products that we manufacture. These
costs are dependent on the status of projects under development and may vary
substantially between quarterly or annual reporting periods. During the
remainder of 2004, we expect to incur additional incremental costs associated
with the manufacture of developmental lots and clinical trial lots for our
blood screening products and with the TIGRIS instrument. Collaborative research
revenues, if any, associated with these types of incurred costs have typically
been realized in a period later than when incurred. Critical accounting policies and estimates Our discussion and analysis of our financial condition and results of
operations is based on our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and related disclosure of contingent assets
and liabilities. On an ongoing basis, we evaluate our estimates, including
those related to revenue recognition, the collectibility of accounts
receivable, valuation of inventories, long-lived assets including patent costs 14




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and capitalized software and income taxes. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities. Senior
management has discussed the development, selection and disclosure of these
estimates with the Audit Committee of our Board of Directors. Actual results
may differ from these estimates under different assumptions or conditions. We believe there have been no significant changes to our critical
accounting policies and estimates as disclosed in Managements Discussion and
Analysis of Financial Condition and Results of Operations in our Annual Report
on Form 10-K for the year ended December 31, 2003, except for the item(s)
discussed below. Capitalized software costs We capitalize costs incurred in the development of computer software
related to products under development after establishment of technological
feasibility. These capitalized costs are recorded at the lower of unamortized
cost or net realizable value and are amortized over the estimated life of the
related product.. At June 30, 2004, capitalized software development costs
related to our TIGRIS instrument totaled $24.7 million, net. We completed beta
evaluations of this instrument for clinical diagnostic applications and
undertook initial beta trials for blood screening applications in the third
quarter of 2002 and we completed a clinical trial for a diagnostic application
in June 2003. In December 2003, we received approval from the FDA for testing
certain STDs on the TIGRIS instrument. We initiated clinical trials of our
Procleix Ultrio assay on the TIGRIS instrument for a blood screening
application in January 2004. If we are not able to successfully deliver this
instrument to the marketplace and attain customer acceptance, the asset could
be impaired and an adjustment to the carrying value of this asset would be
considered by management at that time. In accordance with SFAS No. 86, Accounting for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed, we began amortizing the
capitalized software costs on a straight-line basis over 120 months during the
second quarter of 2004, coinciding with the general release of TIGRIS
instruments to our customers. Results of Operations The following table sets forth operating data as a percentage of total
revenues on a comparable basis for the three and six month periods ended June
30, 2004 and 2003. The information for each of these periods is unaudited and
has been prepared in accordance with accounting principles generally accepted
in the United States for interim financial information. In the opinion of
management, all necessary adjustments, consisting only of normal recurring
accruals, have been included to fairly present the unaudited quarterly results
when read in conjunction with our audited financial statements and related
notes. Past operating results are not necessarily indicative of future results. The following table sets forth unaudited operating data as a percentage of
total revenues: Three Months
    
    Six MonthsEnded June 30,
    
    Ended June 30,2004
    
    2003
    
    2004
    
    2003Total revenues
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Product sales
    
    
    86
    %
    
    
    91
    %
    
    
    78
    %
    
    
    93
    %Collaborative research revenue
    
    
    11
    %
    
    
    8
    %
    
    
    10
    %
    
    
    6
    %Royalty and license revenue
    
    
    3
    %
    
    
    1
    %
    
    
    12
    %
    
    
    1
    %Operating expenses:Cost of product sales
    
    
    22
    %
    
    
    22
    %
    
    
    19
    %
    
    
    25
    %Research and development
    
    
    26
    %
    
    
    32
    %
    
    
    25
    %
    
    
    29
    %Marketing and sales
    
    
    11
    %
    
    
    12
    %
    
    
    10
    %
    
    
    11
    %General and administrative
    
    
    12
    %
    
    
    11
    %
    
    
    11
    %
    
    
    10
    %Total operating expenses
    
    
    71
    %
    
    
    77
    %
    
    
    65
    %
    
    
    75
    %Income from operations
    
    
    29
    %
    
    
    23
    %
    
    
    35
    %
    
    
    25
    %Total other income (expense)
    
    
    0
    %
    
    
    1
    %
    
    
    1
    %
    
    
    1
    %Income before income taxes
    
    
    29
    %
    
    
    24
    %
    
    
    36
    %
    
    
    26
    %Income tax expense
    
    
    10
    %
    
    
    8
    %
    
    
    13
    %
    
    
    9
    %Net income
    
    
    19
    %
    
    
    16
    %
    
    
    23
    %
    
    
    17
    %
 15




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Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003
(Percentages have been rounded to the nearest whole percentage) Product sales Product sales increased $6.3 million, or 14%, to $52.6 million during the
three months ended June 30, 2004, from $46.3 million in the same period of the
prior year. The increase was primarily the result of a $3.6 million increase in
worldwide commercial sales of our Procleix blood screening products, a $1.1
million increase in STD product sales, primarily APTIMA, and a $1.6 million
increase in sales of other diagnostic products. Procleix blood screening
product sales represented $22.1 million, or 42% of product sales, for the three
months ended June 30, 2004, compared to $18.5 million, or 40% of product sales,
for the three months ended June 30, 2003. We expect competitive pressures related to our STD and blood screening
products to continue into the foreseeable future, primarily as a result of the
introduction of competing products into the market and continuing pricing
pressure, particularly with our STD products. Collaborative research revenue Collaborative research revenue increased $3.2 million, or 84%, to $7.0
million during the three months ended June 30, 2004, from $3.8 million in the
same period of the prior year. The increase was primarily the result of a $4.7
million increase in firm support commitment payments in connection with the WNV
tests provided to United States customers through our collaboration with
Chiron. This increase was partially offset by a $0.6 million decrease in
revenue for reimbursement from Chiron of our development costs incurred on the
Procleix Ultrio assay and a $0.6 million decrease in revenue from the NIH to
develop a NAT assay for the detection of WNV. Royalty and license revenue Royalty and license revenue increased $1.1 million to $1.6 million in the
three months ended June 30, 2004, from $0.5 in the same period of the prior
year. The increase was attributed to a $1.1 million increase in net license
income from Bayer for the licensing of rights to certain patented technology. Cost of product sales Cost of product sales increased $2.1 million to $13.2 million, or 25% of
product sales in the three months ended June 30, 2004, from $11.1 million, or
24% of product sales, in the same period of the prior year. The $2.1 million
increase in cost of sales was principally attributed to the volume increase in
product sales and the amortization of capitalized software development costs
related to our TIGRIS instrument during the period. Cost of product sales may
fluctuate significantly in future periods based on changes in production
volumes for both commercially approved products and products under development
or in clinical trials. Cost of product sales are also affected by manufacturing
efficiencies, allowances for scrap or obsolete materials, additional costs
related to initial production quantities of new products after achieving FDA
approval, and contractual adjustments, such as instrumentation costs,
instrument service costs and royalties. Our gross profit margin on product sales decreased to 75% in the three
months ended June 30, 2004, from 76% in the same period of the prior year due,
in part, to the amortization of capitalized software development costs of $0.4
million, which began in the second quarter of 2004. Research and development Our research and development expenses include salaries and other
personnel-related expenses, temporary personnel expenses, outside services,
laboratory and manufacturing supplies, pre-commercial development lots and
clinical evaluation trials. Research and development expenses decreased $0.5
million to $15.9 million, or 26% of total revenues, in the three months ended
June 30, 2004, from $16.4 million, or 32% of total revenues, in the same period
of the prior year. The decrease was primarily the result of a $4.5 million
decrease in inventory used due to lower development lot production, which was
partially offset by a $2.5 million increase in expenses resulting from higher
staffing levels to support product development projects and a $1.1 million
increase in expenses related to clinical trials for blood bank. 16




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Marketing and sales Our marketing and sales expenses include personnel costs, promotional
expenses, and outside services. Marketing and sales expenses increased $0.7
million to $6.6 million, or 11% of total revenues, in the three months ended
June 30, 2004, from $5.9 million, or 12% of total revenues, in the same period
of the prior year. The increased spending principally included expenses to
support increases in sales of our clinical diagnostic products, including a
$0.2 million increase for printing and promotional costs related to the
marketing of TIGRIS. General and administrative Our general and administrative expenses include personnel costs for
finance, legal, public relations, human resources and business development, as
well as professional fees, such as expenses for legal, patents and auditing
services. General and administrative expenses increased $2.1 million to $7.5
million, or 12% of total revenues, in the three months ended June 30, 2004,
from $5.4 million, or 11% of total revenues, in the same period of the prior
year. The increased spending included a $1.1 million increase in expenses
resulting from higher staffing levels, including expenses from our majority
owned subsidiary, Molecular Light Technology Limited (acquired in August 2003),
and a $0.6 million increase in patent and legal related expenses, primarily
related to the ongoing Bayer arbitration. Total other income (expense) Other income (expense) generally consists of investment and interest
income offset by interest expense on borrowing, minority interest, and other
items. The net other income of $21,000 in the three months ended June 30, 2004
represented a $435,000 decrease from the net other income of $456,000 in the
same period of the prior year. The decrease was primarily due to realized
market losses in our investment portfolio of government bonds, coinciding with
our recent shift in investment emphasis from U.S. Treasury bonds to tax free
municipal bonds, bond interest rates increased approximately 100 basis points
during the second quarter of 2004, resulting in market losses for lower yield
bonds as they were sold. If these available for sale securities had been held
to maturity, most of these realized market losses would have been recorded
through stockholders equity as other comprehensive income or loss. The
Company expects to achieve a long term benefit with the tax free securities. Income tax expense Income tax expense increased to $6.4 million, or 35% of pretax income, in
the three months ended June 30, 2004, from $4.2 million, or 34% of pretax
income, in the same period of the prior year. The increased effective tax rate
in 2004 is attributed to higher profits taxed at the combined Federal and state
statutory tax rate of approximately 41%, partially offset by the benefit of
Federal and state research and investment credits. Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003
(Percentages have been rounded to the nearest whole percentage) Product sales Product sales increased $17.7 million, or 20%, to $107.6 million during
the six months ended June 30, 2004, from $89.9 million in the same period of
the prior year. The increase was primarily the result of a $10.1 million
increase in worldwide commercial sales of our Procleix blood screening
products, a $5.5 million increase in STD product sales, primarily APTIMA, and a
$2.1 million increase in sales of our other diagnostic products. Procleix blood
screening product sales represented $45.1 million, or 42% of product sales, for
the six months ended June 30, 2004, compared to $35.0 million, or 39% of
product sales, for the six months ended June 30, 2003. Collaborative research revenue Collaborative research revenue increased $8.0 million, or 140%, to $13.7
million during the six months ended June 30, 2004, from $5.7 million in the
same period of the prior year. The increase was primarily the result of a $9.2
million increase in firm support commitment payments in connection with the WNV
tests provided to United States customers through our collaboration with
Chiron. Further, we recognized $0.5 million additional revenues from the NIH
to develop a NAT assay for the detection of WNV. These increases were partially
offset by a $1.5 million decrease in revenue for reimbursement from Chiron of
our development costs incurred on the Procleix Ultrio assay. We recognized $1.3
million in revenue during the first quarter of 2003 for work performed during
2002 and 2001 in connection our collaboration with Chiron. 17




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Royalty and license revenue Royalty and license revenue increased $15.1 million to $16.3 million in
the six months ended June 30, 2004, from $1.2 million in the same period of the
prior year. The increase was attributed to $7.0 million in license fees earned
from Tosoh as part of our non-exclusive licensing agreement relating to NAT
technologies effective in January 2004, and $6.5 million in milestone revenue
from Chiron as the Company began clinical trial testing in the United States of
the Procleix Ultrio assay on the fully automated TIGRIS instrument.
Additionally, we recognized $1.5 million in net license income from Bayer
during the six months ended June 30, 2004 for the licensing of rights to
certain patented technology. Cost of product sales Cost of product sales increased $3.0 million to $27.0 million, or 25% of
product sales, in the six months ended June 30, 2004, from $24.0 million, or
27% of product sales, in the same period of the prior year. The $3.0 million
increase in cost of sales was principally attributed to the volume increase in
product sales and the amortization of capitalized software development costs. Our gross profit margin on product sales increased to 75% in the six
months ended June 30, 2004, from 73% in the same period of the prior year. The
gross profit margin benefited from certain manufacturing costs absorbed by
research and development for the production of pre-commercial development lots,
partially offset by amortization of the TIGRIS instrument capitalized software
which began in the second quarter of 2004. Research and development Our research and development expenses include salaries and other
personnel-related expenses, temporary personnel expenses, outside services,
laboratory and manufacturing supplies, pre-commercial development lots and
clinical evaluation trials. Research and development expenses increased $6.6
million to $34.3 million, or 25% of total revenues, in the six months ended
June 30, 2004, from $27.7 million, or 29% of total revenues, in the same period
of the prior year. The increased spending was primarily the result of a $5.1
million increase in expenses resulting from higher staffing levels to support
product development projects, a $2.0 million increase in expenses related to
clinical trials for blood screening products and a $0.8 million increase in
research and development expenses from our subsidiary, Molecular Light
Technology Limited (acquired in August 2003), partially offset by a $1.6
million decrease in the unit costs of clinical lots produced for our WNV
project. Marketing and sales Our marketing and sales expenses include personnel costs, promotional
expenses, and outside services. Marketing and sales expenses increased $2.8
million to $13.4 million, or 10% of total revenues, in the six months ended
June 30, 2004, from $10.5 million, or 11% of total revenues, in the same period
of the prior year. The increased spending principally included a $2.1 million
increase in salaries, benefits, commissions and other personnel related costs
in our marketing and sales force to support increases in sales for our clinical
diagnostic products, together with a $0.4 million increase for advertising and
promotional costs related to the marketing of our TIGRIS instrument. General and administrative Our general and administrative expenses include personnel costs for
finance, legal, public relations, human resources and business development, as
well as professional fees, such as expenses for legal, patents and auditing
services. General and administrative expenses increased $4.8 million to $14.8
million, or 11% of total revenues, in the six months ended June 30, 2004, from
$10.0 million, or 10% of total revenues, in the same period of the prior year.
The increased spending included a $2.3 million increase in expenses resulting
from higher staffing levels, including expenses from our majority owned
subsidiary, Molecular Light Technology Limited (acquired in August 2003), and a
$1.7 million increase in patent and legal related expenses, primarily related
to the ongoing Bayer arbitration. 18




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Total other income (expense) Other income (expense) generally consists of investment and interest
income offset by interest expense on borrowing, minority interest, and other
items. The net other income of $698,000 in the six months ended June 30, 2004
represented a $208,000 decrease from the net other income of $906,000 in the
same period of the prior year. The decrease was primarily due to a $179,000
increase in minority interest expense from our subsidiary, Molecular Light
Technology Limited, and a $115,000 decrease in realized foreign exchange rate
losses from our sales to Canadian customers. Income tax expense Income tax expense increased to $17.5 million, or 36% of pretax income, in
the six months ended June 30, 2004, from $8.8 million, or 34% of pretax income,
in the same period of the prior year. The increased effective tax rate in 2004
is attributed to higher profits taxed at the combined Federal and state
statutory tax rate of approximately 41%, partially offset by the benefit of
Federal and state research and investment credits. Liquidity and capital resources Historically, we have financed our operations through cash from
operations, cash received from collaborative research agreements, royalty and
license fees, the private placement of debt and cash from capital
contributions. At June 30, 2004, we had $192.8 million of cash and cash
equivalents and short-term investments. For the six months ended June 30, 2004, net cash provided by operating
activities was $33.4 million, compared to $18.6 million in the same period of
the prior year. The increase in net cash during the six months ended June 30,
2004 was principally the result of net income of $31.5 million, depreciation
and amortization of $8.4 million and an $8.1 million increase in income taxes
payable, partially offset by a $6.5 million increase in accounts receivable and
a $12.5 million increase in inventory. Our
investing activities, which used cash of $54.0 million for the six
months ended June 30, 2004, consisted of purchases, net of proceeds of $44.2
million for short-term investments and $8.8 million for capital expenditures.
Our expenditures for capital additions vary based on the stage of development
projects and may increase in the future related to the timing of development of
new product opportunities and to support expansion of our facilities in
connection with those opportunities. The average age of our property, plant and
equipment is approximately five years, which gives us flexibility in planning
capital expenditures. Net cash provided by financing activities for the six months ended June
30, 2004, was the result of $12.3 million in proceeds from stock option
exercises and purchases made through our Employee Stock Purchase Plan, or ESPP.
Cash from financing activities will be affected by receipts from sales of stock
under our ESPP and from the exercise of stock options. We expect fluctuations
to occur throughout the year, as the amount and frequency of stock-related
transactions are dependent upon the market performance of our common stock,
together with other factors. We have an unsecured bank line of credit agreement with Wells Fargo Bank,
N.A., which expires in July 2005, under which we may borrow up to $10.0
million, subject to a borrowing base formula, at the banks prime rate, or at
LIBOR plus 1.0%. We have not taken advances against the line of credit since
its inception. The line of credit agreement requires us to comply with various
financial and restrictive covenants. Financial covenants include requirements
as to tangible net worth, liabilities as a percentage of tangible net worth,
the ratio of current assets to current liabilities, required minimum levels of
earnings before interest, taxes, depreciation and amortization, the ratio of
funded debt to earnings before interest, taxes, depreciation and amortization,
and maximum levels of pre-tax and after tax losses. At December 31, 2003 and
June 30, 2004, we were in compliance with all covenants and had no outstanding
borrowings under this line of credit. In July 2004, we commenced the construction of an additional building at
our Genetic Center Drive location. This new building will consist of an
approximately 291,000 square foot outside shell, with approximately 160,000
square feet built out with interior improvements. The additional space that
will not initially be built out will allow for future expansion. The first
phase of this project is estimated to take two years for completion and is
currently estimated to cost approximately $45.0 million. These costs will be
capitalized as incurred and depreciation will commence upon our completion and
use, which is planned for early 2006. We plan to implement a new Enterprise Resource Planning, or ERP, software
system, which currently is estimated to represent an approximately $6.5 to $8.0
million expenditure. The majority of these costs will be capitalized and
amortization will commence upon our placement of the new ERP system into
service, which is currently planned for January 2005. 19




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Further, we expect to incur approximately $10.0 million to purchase TIGRIS
instruments that will be added to our installed base during 2004. Contractual obligations and commercial commitments In connection with the joint development of the Procleix HIV-1/HCV assay,
and as a condition for Chirons agreement to pay for most of the clinical trial
costs related to approval of that assay, we agreed to pay the costs related to
the clinical trial for the next joint development project with Chiron. Our
obligation is limited to the cost incurred for the previous joint clinical
trial, which was approximately $4.1 million. As of June 30, 2004, we had
incurred approximately $3.7 million of clinical trial expenses as a result of
this obligation to Chiron and we anticipate that our obligation to pay these
costs will satisfied during the second half of 2004. In November 2003, we entered into a license and collaboration agreement
with DiagnoCure under which we agreed to develop in collaboration with
DiagnoCure, and we agreed to market, a test to detect a new gene marker for
prostate cancer. Under the terms of the agreement, we agreed to pay DiagnoCure
an upfront fee of $3.0 million, and future fees and contract development
payments of up to $7.5 million over the next three years. Our primary short-term needs for capital, which are subject to change, are
for continued research and development of new products, costs related to
commercialization of blood screening products and purchases of the TIGRIS
instruments for placement with our customers. Certain research and development
costs are funded under collaboration agreements with partners or agencies of
the United States government. We anticipate additional funds from these sources
as reimbursable costs are incurred, but these funds may not materialize and
these relationships may not continue. We believe that our available cash balances, anticipated cash flows from
operations and available line of credit will be sufficient to satisfy our
operating needs for the foreseeable future. However, we operate in a rapidly
evolving and often unpredictable business environment that may change the
timing or amount of expected future cash receipts and expenditures.
Accordingly, we may in the future be required to raise additional funds through
the sale of equity or debt securities or from additional credit facilities.
Additional capital, if needed, may not be available on satisfactory terms, if
at all. Furthermore, additional debt financing may contain more restrictive
covenants than our existing debt. We may from time to time consider the acquisition of businesses and/or
technologies complementary to our business. We could require debt and/or equity
financing if we were to engage in a material acquisition in the future. In
August 2003, we filed a Form S-3 shelf registration statement with the SEC
relating to the possible future sale of up to an aggregate of $150 million of
debt and/or equity securities. Risk Factors The following information sets forth facts that could cause our actual
results to differ materially from those contained in forward-looking statements
we have made in this Quarterly Report and those we may make from time to time. Our quarterly revenue and operating results may vary significantly in future
periods and our stock price may decline. Our operating results have fluctuated in the past and are likely to
continue to do so in the future. Our revenues are unpredictable and may
fluctuate due to changes in demand for our products, the timing of the
execution of customer contracts and the initiation or termination of corporate
collaboration agreements. Our product revenues, particularly in bloodscreening,
may vary significantly from quarter to quarter based upon fluctuations in blood
donations and reportable bloodscreening results. A significant portion of our
costs also can vary substantially between quarterly or annual reporting
periods. For example, the total amount of research and development costs in a
period often depends on the amount of research and development costs we incur
in connection with manufacturing developmental lots and clinical trial lots. We
incurred substantial costs of manufacturing these lots in 2003 and the first
half of 2004 and will continue to incur expense through the remainder of 2004
and beyond as we seek FDA approval of our Procleix Ultrio assay and the WNV
assay. Moreover, a variety of factors may affect our ability to make accurate
forecasts regarding our operating results. For example, our blood screening
products and some of our clinical diagnostic products, such as APTIMA Combo 2,
have a relatively limited sales history, which limits our ability to project
future sales accurately. Our share of revenue from commercial sales of assays
that test for HCV under our blood screening collaboration with Chiron decreased
to 45.75% of net revenues as of January 1, 2004, as a result of the recent
amendment to our collaboration agreement with Chiron. In addition, we base our
internal projections of our international sales on projections prepared by our
distributors of these products. Because of all of these factors, our operating
results in one or more future quarters may fail to meet or exceed financial
guidance we may provide from time to time and the expectations of 20




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securities analysts or investors, which could cause our stock price to
decline. We are dependent on Chiron and other third parties for the distribution of
some of our products. If any of our distributors terminates its relationship
with us or fails to adequately perform, our product sales will suffer. We rely on Chiron to distribute our blood screening products and Bayer to
distribute some of our viral clinical diagnostic products. Commercial product
sales by Chiron accounted for 33% of our total revenues for the six months
ended June 30, 2004 and 37% of our total revenues for 2003. Our agreements with
Chiron and Bayer will terminate in 2010 unless extended. Both the Chiron and
Bayer agreements can be extended by the development of new products under the
agreements, in which case they will expire upon the later of the end of the
original term or five years after the first commercial sale of the last new
product developed during the original term. In February 2001, we commenced an arbitration proceeding against Chiron in
connection with our blood screening collaboration. The arbitration related
primarily to the propriety of various deductions from gross revenues made by
Chiron prior to calculating Gen-Probes share of revenues and the parties
respective shares of revenues received from The American Red Cross prior to FDA
approval of the Procleix HIV-1/HCV blood screening assay. Other disputed items
included the parties respective obligations in connection with clinical trials
of the Procleix HIV-1/HCV blood screening assay and future assays, Chirons
obligation to purchase blood screening assays in compliance with its forecasts
and the parties respective obligations with respect to royalties to be paid on
a patent license from a third party. By December 2001, we negotiated a
resolution to most of the disputed items, and in January 2002, we received $6.9
million in partial settlement of the claims. In the event that we or Chiron
commence arbitration against each other in the future under the collaboration
agreement, proceedings could delay or decrease our receipt of revenue from
Chiron or otherwise disrupt our collaboration with Chiron, which could cause
our revenues to decrease and our stock price to decline. In November 2002, we initiated an arbitration proceeding against Bayer in
connection with our clinical diagnostic collaboration. Under the terms of the
collaboration agreement, Bayer acquired the exclusive right to distribute
nucleic acid diagnostic tests designed and developed by us for the detection of
HIV, hepatitis virus and other specified viruses, subject to specific
conditions. Our demand for arbitration stated that Bayer has failed to fulfill
the conditions required to maintain exclusive distribution rights. Accordingly,
we are seeking confirmation that the agreement grants us, in the present
circumstances, a co-exclusive right to directly distribute the viral diagnostic
tests that are the subject of the agreement. Our arbitration demand also seeks
money damages due to Bayers failure to use commercially reasonable efforts to
promote, market and sell viral diagnostic assays developed by us. In November
2003, Bayer filed a counterclaim for money damages based on alleged delays in
the development of the TIGRIS instrument and certain assays, and other claims.
The matter has been set for hearing beginning on September 13, 2004. There can
be no assurances as to the final outcome of the arbitration. We rely upon bioMérieux for distribution of some of our products in most
of Europe, Rebio Gen, Inc. for distribution of some of our products in Japan
and various independent distributors for distribution of our products in other
regions. Our distribution agreement with bioMérieux terminates on May 1, 2006,
although it may terminate earlier under certain circumstances. The distribution
rights revert back to Gen-Probe upon termination. Our distribution agreement
with Rebio Gen, terminates on December 31, 2005. If any of our distribution or marketing agreements is terminated,
particularly our agreement with Chiron, and we are unable to enter into an
alternative agreement or if we elect to distribute our products directly, we
would have to invest in additional sales and marketing resources, including
additional field sales personnel, which would significantly increase future
selling, sales and marketing and general and administrative expenses. We may
not be able to enter into new distribution or marketing agreements on
satisfactory terms, or at all. If we fail to enter into acceptable distribution
or marketing agreements or fail to market successfully our products, our
product sales would decrease. If we cannot maintain our current corporate collaborations and enter into new
corporate collaborations, our product development could be delayed. In
particular, any failure by us to maintain our collaboration with Chiron with
respect to blood screening would have a material adverse effect on our
business. We rely, to a significant extent, on our corporate collaborators for the
joint development and marketing of our products. If any of our corporate
collaborators were to breach or terminate its agreement with us or otherwise
fail to conduct their collaborative activities successfully and in a timely
manner, the pre-clinical or clinical development or commercialization and
subsequent marketing of the products contemplated by the collaboration could be
delayed or terminated. We cannot control the amount and timing of resources our
corporate collaborators devote to our programs or potential products. In
addition, we expect to rely on our corporate collaborators for the
commercialization of some of our products. 21




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The continuation of any of our collaboration agreements may depend on the
periodic renewal of our corporate collaborations. Our agreements with Chiron and Bayer will terminate in 2010 unless extended by
the development of new products under the agreements, so that they will expire
upon the later of the original term or five years after the first commercial
sale of the last new product developed during the original term. Both
collaboration agreements are also subject to termination prior to expiration
upon a material breach by either party to the agreement. If any of our collaboration agreements is terminated, or if we are unable
to renew those collaborations on acceptable terms, we would be required to
devote additional internal resources to product development or marketing or to
terminate some development programs or seek alternative corporate
collaborations. We may not be able to negotiate additional corporate
collaborations on acceptable terms, if at all, and these collaborations may not
be successful. Market demand for our new TIGRIS instrument may be difficult to predict. If
we are unable to deliver and support the TIGRIS instrument, we may be unable
to retain our existing customers and attract new customers. We believe the fully-automated TIGRIS instrument offers significant
economic and technical advantages to customers. However, the TIGRIS instrument
will be more expensive for customers to purchase or lease than our existing
semi-automated instrument systems. The comparatively higher cost of this new
instrument makes it difficult to accurately predict market demand. Because the
commercial launch of the TIGRIS instrument is currently underway for use with
our APTIMA Combo 2 assay, we do not have a history of TIGRIS instrument sales
or leases on which to accurately base predictions of market demand. Additionally, diagnostic instruments as innovative and complex as the
TIGRIS instrument may require frequent service during the period of their
initial introduction. We expect to bear the expense of such service costs for
most customers. We do not have a history of providing service for TIGRIS
instruments and our service costs will depend upon the ultimate reliability of
the instrument in the field. We face intense competition, and our failure to compete effectively could
decrease our revenues and harm our profitability and results of operations. The clinical diagnostics industry is highly competitive. Currently, the
majority of diagnostic tests used by physicians and other health care providers
are performed by large reference laboratories, public health laboratories and
hospitals. We expect that these laboratories will compete vigorously to
maintain their dominance in the diagnostic testing market. In order to achieve
market acceptance of our products, we will be required to demonstrate that our
products provide accurate, cost-effective and time saving alternatives to tests
performed by traditional laboratory procedures and products made by our
competitors. In the markets for clinical diagnostic products, a number of competitors,
including F. Hoffmann-La Roche Ltd. and its subsidiary, Roche Molecular
Diagnostics, Inc., Abbott Laboratories, Becton Dickinson and Company and
bioMérieux S.A., compete with us for product sales, primarily on the basis of
technology, quality, reputation, accuracy, ease of use, price, reliability, the
timing of new product introductions and product line offerings. In markets
outside of the United States, other factors, including local distribution
systems, complex regulatory environments and differing medical philosophies and
product preferences, influence competition as well. Some of our competitors
have, and in the future these and other competitors may have, significantly
greater financial, marketing, sales, manufacturing, distribution and
technological resources than us. Moreover, these companies may have
substantially greater expertise in conducting clinical trials and research and
development, greater ability to obtain necessary intellectual property licenses
and greater brand recognition than we do. In addition, we have licensed some of
our proprietary technology relating to certain clinical diagnostic and food
pathogen applications for use on specific instruments to bioMérieux, and we may
license other technologies to potential competitors in the future. As a result,
we may in the future compete with bioMérieux and these other licensees for
sales of products incorporating our technology. Our competitors may be in a
stronger position to respond quickly to new or emerging technologies, may be
able to undertake more extensive marketing campaigns, may adopt more aggressive
pricing policies and may be more successful in attracting potential customers,
employees and strategic partners than we are. While our current products incorporate end-point detection methods, we
believe that our competitors are developing real time or kinetic nucleic acid
assays and are developing semi-automated instrument systems to perform real
time assays. Our competitors may be further in the development process with
respect to such assays and instrumentation then we are. In the market for blood screening products, our primary competitor is
Roche Molecular Systems, which received FDA approval of its Polymerase Chain
Reaction, or PCR, based NAT tests for blood screening in December 2002. We also
compete with assays developed internally by blood banks and laboratories based
on PCR technology, an HCV antigen assay marketed by Ortho Clinical Diagnostics,
a subsidiary of Johnson & Johnson, and immunoassay products from Abbott
Laboratories. In the future, our blood screening products also may compete with
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Chiron, with whom we have entered into a collaboration agreement for our
blood screening products, retains certain rights to grant licenses of the
patents related to HCV and HIV to third parties in blood screening. Chiron has
granted HIV and HCV licenses to Roche Molecular Systems in the blood screening
and clinical diagnostics fields. Chiron has granted HIV and HCV licenses in the
clinical diagnostic field to Bayer Healthcare LLC, which also has the right to
grant certain additional HIV and HCV sublicenses in the field to third parties.
Chiron has granted an HCV license to Abbott and an HIV license to Organon
Teknika (now bioMeriuex). To the extent that Chiron grants additional licenses
in blood screening or Bayer grants additional licenses in clinical diagnostics,
further competition will be created for sales of HCV and HIV assays and these
licenses could affect the prices that can be charged for our products. Our profit margin on the sale of blood screening assays may decrease upon the
implementation of individual donor testing. We currently receive revenues from the sale of the Procleix HIV-1/HCV
blood screening assay for use with pooled donor samples. In pooled testing,
multiple donor samples are initially screened by a single test, however, Chiron
sells our Procleix HIV-1/HCV assay to blood collection centers on a per
donation basis. We expect the blood screening market to ultimately transition
from pooled testing to individual donor testing. A greater number of tests will
be required for individual donor testing than are now required for pooled
testing. Under our collaboration agreement with Chiron, we bear the cost of
manufacturing our Procleix HIV-1/HCV assay. The greater number of tests
required for individual donor testing will increase our variable manufacturing
costs, including costs of raw materials and labor. If the price per donor or
total sales volume does not increase in line with the increase in our total
variable manufacturing costs, our gross profit margins from sales of the blood
screening assay may decrease upon the adoption of individual donor testing. We
are not able to accurately predict the extent to which our gross profit margin
may be negatively affected as a result of individual donor testing because we
do not know the ultimate selling price that Chiron would charge to the end user
if individual donor testing were implemented. Because we depend on a small number of customers for a significant portion of
our total revenues, the loss of any of these customers or any cancellation or
delay of a large purchase by any of these customers could significantly
reduce our revenues. Historically, a limited number of customers has accounted for a
significant portion of our total revenues, and we do not have any long-term
commitments with these customers other than our collaboration agreement with
Chiron. Our blood screening collaboration with Chiron accounted for 46% of our
total revenues for the six months ended June 30, 2004 and 42% of our total
revenues for 2003. Our blood screening collaboration with Chiron is largely
dependent on two large customers in the United States, The American Red Cross
and Americas Blood Centers, although we did not receive any revenues directly
from those entities. Chiron was our only customer that accounted for greater
than 10% of our total revenues for the six months ended June 30, 2004. In
addition, Quest Diagnostics Incorporated, Laboratory Corporation of America
Holdings and various state and city public health agencies accounted for an
aggregate of 18% of our total revenues for the six months ended June 30, 2004
and 21% of our total revenues for 2003. Although state and city public health
agencies are legally independent of each other, they tend to act similarly with
respect to their product purchasing decisions. We anticipate that our operating
results will continue to depend to a significant extent upon revenues from a
small number of customers. The loss of any of our key customers, or a
significant reduction in sales to those customers, could significantly reduce
our revenues. The intellectual property rights on which we rely to protect the technologies
underlying our products may be inadequate to prevent third parties from using
our technologies or developing competing products. Our success will depend in part on our ability to obtain patent protection
for, or maintain the secrecy of, our proprietary products, processes and other
technologies for development of blood screening and clinical diagnostic
products and instruments. Although we have 184 United States patents and 160
foreign patents, these patents, or any patents that we may own or license in
the future, may not afford meaningful protection for our technology and
products. The pursuit and assertion of a patent right, particularly in areas
like nucleic acid diagnostics and biotechnology, involve complex determinations
and, therefore, are characterized by substantial uncertainty. In addition, the
laws governing patentability and the scope of patent coverage continue to
evolve, particularly in biotechnology. As a result, patents might not issue
from certain of our patent applications or from applications licensed to us. In
addition, all of our existing patents will expire by May 1, 2021, and the
patents we may obtain in the future also will expire over time. The scope of any of our issued patents may not be broad enough to offer
meaningful protection. In addition, others may challenge our current patents or
patents we may obtain in the future and, as a result, these patents could be
narrowed, invalidated or rendered unenforceable, or we may be forced to stop
using the technology covered by these patents or to license technology from
third parties. Moreover, the laws of some foreign countries may not protect our
proprietary rights to the same extent as do the laws of the United States. Any
patents issued to us or our strategic partners may not provide us with any
competitive advantages, and the patents held by other parties may limit our
freedom to conduct our business or use our technologies. Our efforts to enforce
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property rights may not be successful and may result in substantial costs
and diversion of management time. Even if our rights are valid, enforceable and
broad in scope, competitors may develop products based on technology that is
not covered by our patents. In addition to patent protection, we also rely on copyright and trademark
protection, trade secrets, know-how, continuing technological innovation and
licensing opportunities. In an effort to maintain the confidentiality and
ownership of our trade secrets and proprietary information, we require our
employees, consultants, advisors and others to whom we disclose confidential
information to execute confidentiality and proprietary information agreements.
However, it is possible that these agreements may be breached, invalidated or
rendered unenforceable, and if so, there may not be an adequate corrective
remedy available. Furthermore, like many companies in our industry, we may from
time to time hire scientific personnel formerly employed by other companies
involved in one or more areas similar to the activities we conduct. In some
situations, our confidentiality and proprietary information agreements may
conflict with, or be subject to, the rights of third parties with whom our
employees, consultants or advisors have prior employment or consulting
relationships. Although we require our employees and consultants to maintain
the confidentiality of all confidential information of previous employers, we
or these individuals may be subject to allegations of trade secret
misappropriation or other similar claims as a result of their prior
affiliations. Finally, others may independently develop substantially
equivalent proprietary information and techniques, or otherwise gain access to
our trade secrets. Our failure to protect our proprietary information and
techniques may inhibit or limit our ability to exclude certain competitors from
the market and execute our business strategies. The diagnostic products industry has a history of patent and other
intellectual property litigation, and we may be involved in costly
intellectual property lawsuits. The diagnostic products industry has a history of patent and other
intellectual property litigation, and these lawsuits likely will continue.
Because we produce and provide many different products and services in this
industry, we have faced in the past, are currently facing, and may face in the
future, patent infringement suits by companies that control patents for similar
products and services or other suits alleging infringement of their
intellectual property rights. In order to protect or enforce our intellectual
property rights, we may have to initiate legal proceedings against third
parties. Legal proceedings relating to intellectual property typically are
expensive, take significant time and divert managements attention from other
business concerns. The cost of this litigation could adversely affect our
results of operations, making us less profitable. Further, if we do not prevail
in an infringement lawsuit brought against us, we might have to pay substantial
damages, including treble damages, and we could be required to stop the
infringing activity or obtain a license to use the patented technology. We have been involved in a number of patent disputes with third parties, a
number of which remain unresolved. Most recently, in February 2004, we filed a
patent infringement action in the United States District Court for the Southern
District of California alleging that Bayers bDNA nucleic acid tests for HIV
and HCV infringe certain of our patents. In addition, we are in litigation with
Enzo Biochem Inc. which claims that genetic sequences used in certain of our
gonorrhea testing products infringe one of its patents. We are also in
litigation with Vysis, Inc. regarding the validity of a Vysis patent that
Vysis asserts covers the target capture technology that we employ in some of
our amplified NAT assays. We may be subject to future product liability claims that may exceed the
scope and amount of our insurance coverage, which would expose us to
liability for uninsured claims. While there is a federal preemption defense against product liability
claims for medical products that receive premarket approval from the FDA, we
believe that no such defense is available for our products that we market under
a 510(k) clearance. As such, we are subject to potential product liability
claims as a result of the design, development, manufacture and marketing of our
clinical diagnostic products. Any product liability claim brought against us,
with or without merit, could result in the increase of our product liability
insurance rates. In addition, we would have to pay any amount awarded by a
court in excess of our policy limits. Our insurance policies have various
exclusions, and thus we may be subject to a product liability claim for which
we have no insurance coverage, in which case, we may have to pay the entire
amount of any award. In addition, insurance varies in cost and can be difficult
to obtain, and we may not be able to obtain insurance in the future on terms
acceptable to us, or at all. A successful product liability claim brought
against us in excess of our insurance coverage, may require us to pay
substantial amounts, which could harm our business and results of operations. The adoption of the Financial Accounting Standards Board SFAS No. 142,
Goodwill and Other Intangible Assets as of January 1, 2002 could adversely
affect our future results of operations and financial position. In June 2001, the Financial Accounting Standards Board issued SFAS No.
142, Goodwill and Other Intangible Assets, which we adopted effective on
January 1, 2002. Under the new rules, goodwill and intangible assets deemed to
have indefinite lives will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statement. As of June 30, 2004, we had
goodwill and 24




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intangible assets valued at approximately $49.5 million, including $24.7
million of capitalized software relating to the TIGRIS instrument, which we
began amortizing during the second quarter of 2004, and $6.2 million of
capitalized patents and purchased intangibles that have been included in Other
assets on the face of our balance sheet. At December 31, 2003, we performed
our annual impairment tests of goodwill and indefinite lived intangible assets
to determine if an impairment charge should be recognized under SFAS No. 142
and determined that there had been no impairments at that time. In the future,
we will continue to test for impairment at least annually. These tests may
result in a determination that the assets have been impaired. If at any time we
determine that an impairment has occurred, we will be required to reflect the
impaired value as a charge, resulting in a reduction in earnings in the quarter
such impairment is identified and a corresponding reduction in our net asset
value. A material reduction in earnings resulting from such a charge could
cause us to fail to be profitable in the period in which the charge is taken or
otherwise to fail to meet the expectations of investors and securities
analysts, which could cause the price of our stock to decline. Our future success will depend in part upon our ability to enhance existing
products and to develop and introduce new products. The market for our products is characterized by rapidly changing
technology, evolving industry standards and new product introductions, which
may make our existing products obsolete. Our future success will depend in part
upon our ability to enhance our existing products and to develop and introduce
new products, such as our NAT assay to detect WNV. For example, we believe that
we will need to continue to provide new products that can detect a greater
number of organisms from a single sample. We also believe that we must develop
new assays that can be performed on automated instrument platforms, such as the
TIGRIS instrument. The development of new or enhanced products is a complex and uncertain
process requiring the accurate anticipation of technological and market trends,
as well as precise technological execution. In addition, the successful
development of new products will depend on the development of new technologies.
We will be required to undertake time-consuming and costly development
activities and to seek regulatory approval for any new products. We may
experience difficulties that could delay or prevent the successful development,
introduction and marketing of these new products. Regulatory clearance or
approval of any new products may not be granted by the FDA or foreign
regulatory authorities on a timely basis, or at all, and the new products may
not be successfully commercialized. We expect to continue to incur significant research and development expenses,
which may make it difficult for us to maintain profitability. In recent years, we have incurred significant costs in connection with the
development of our blood screening products and the TIGRIS instrument. We
expect our expense levels to remain high in connection with our research and
development as we continue to expand our product offerings and continue to
develop products and technologies in collaboration with our strategic partners.
As a result, we will need to continue to generate significant revenues to
maintain profitability. Although we expect our research and development
expenses as a percentage of revenue to decrease in future years, we may not be
able to generate revenues and may not maintain profitability in the future. Our
failure to maintain profitability in the future would cause the market price of
our common stock to decline. We may not have financing for future capital requirements, which may prevent
us from addressing gaps in our product offerings or improving our technology. Although historically our cash flow from operations has been sufficient to
satisfy working capital, capital expenditure and research and development
requirements, in the future we may need to incur additional debt or issue
equity in order to fund these requirements as well as to make acquisitions and
other investments. If we cannot obtain additional debt or equity financing on
acceptable terms or are limited with respect to incurring additional debt or
issuing equity, we may be unable to address gaps in our product offerings or
improve our technology, particularly through strategic acquisitions or
investments. We may need to raise substantial amounts of money to fund a variety of
future activities integral to the development of our business, including but
not limited to the following:  
    
    for research and development to successfully develop our new technologies and products,
    
    to conduct clinical trials,
    
    to obtain regulatory approval for new products, 25




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
    
    to file and prosecute patent applications and defend and assert patents to protect our technologies,
    
    to retain qualified employees, particularly in light of intense competition for qualified scientists and engineers,
    
    to manufacture additional products ourselves or through third parties,
    
    to market different products to different markets, either through
building our own sales and distribution capabilities or relying on third
parties, and
    
    to acquire new technologies, products or companies. If we raise funds through the issuance of debt or equity, including without
limitation through the issuance of equity or debt securities pursuant to our
Form S-3 shelf registration statement that we filed on August 29, 2003 with the
Securities and Exchange Commission relating to the possible future sale of up
to an aggregate of $150 million of debt or equity securities, any debt
securities or preferred stock issued will have rights, preferences and
privileges senior to those of holders of our common stock in the event of a
liquidation and may contain other provisions that adversely effect the rights
of the holders of our common stock. The terms of the debt securities may impose
restrictions on our operations. If we raise funds through the issuance of
equity or debt convertible into equity, this issuance would dilute your
ownership interest in us. We expect to fund future acquisitions in part by issuing additional
equity. If the price of our equity is unacceptably low or volatile due to
market volatility or other factors, we may not be able to acquire other
companies. We have only one third-party manufacturer for each of our instrument product
lines, which exposes us to increased risks associated with delivery
schedules, manufacturing capability, quality assurance, quality and costs. We have one third-party manufacturer for each of our instrument product
lines. KMC Systems is our only manufacturer of the TIGRIS instrument. MGM
Instruments, Inc. is the only manufacturer of our LEADER series of
luminometers. We are dependent on these third-party manufacturers, and this
dependence exposes us to increased risks associated with delivery schedules,
manufacturing capability, quality control, quality assurance and costs. We have
no firm long-term commitments from KMC Systems, MGM Instruments or any of our
other manufacturers to supply products to us for any specific period, or in any
specific quantity, except as may be provided in a particular purchase order. If
KMC Systems, MGM Instruments or any of our other third-party manufacturers
experiences delays, disruptions, capacity constraints or quality control
problems in its manufacturing operations or becomes insolvent, then product
shipments to our customers could be delayed, which would decrease our revenues
and harm our competitive position and reputation. Further, our business would be harmed if we fail to manage effectively the
manufacturing of our products. Because we place orders with our manufacturers
based on our forecasts of expected demand for our products, if we inaccurately
forecast demand, we may be unable to obtain adequate manufacturing capacity or
adequate quantities of components to meet our customers delivery requirements,
or we may accumulate excess inventories. We may in the future need to find new contract manufacturers to increase
our volumes or to reduce our costs. We may not be able to find contract
manufacturers that meet our needs, and even if we do, qualifying a new contract
manufacturer and commencing volume production is expensive and time consuming.
For example, qualifying a new manufacturer of our TIGRIS instrument would take
approximately twelve months. If we are required or elect to change contract
manufacturers, we may lose revenues, and our customer relationships may suffer. If we or our contract manufacturers are unable to manufacture our products or
our instrument products in compliance with regulatory requirements, in
sufficient quantities, on a timely basis and at acceptable costs, or fail to
develop new or replacement systems, our ability to sell our products will be
harmed. We must manufacture our products in compliance with regulatory
requirements, in sufficient quantities and on a timely basis, while maintaining
product quality and acceptable manufacturing costs. Significant additional work
will be required for scaling-up manufacturing of each new product prior to
commercialization, and we may not successfully complete this work.
Manufacturing and quality control problems have arisen and may arise as we
attempt to scale-up our manufacturing of a new product, and we may not achieve
scale-up in a timely manner or at a commercially reasonable cost, or at all. In
addition, although we expect some of our newer products and products under
development to share production attributes with our existing products,
production of these newer products may require the development of new
manufacturing technologies and expertise. 26




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In addition, the amplified NAT tests that we are producing are
significantly more expensive to manufacture than our non-amplified products. As
we continue to develop new amplified NAT tests in response to market demands
for greater sensitivity, our product costs will increase significantly. We sell
our products in a number of cost-sensitive market segments, and we may not be
able to manufacture these more complex amplified tests at costs that would
allow us to maintain our historical gross margins. In addition, new products
that detect more than one target organism will contain significantly more
complex reagents, which will increase the cost of our manufacturing processes
and quality control testing. We or other parties we engage to help us may not
be able to manufacture these products at a cost or in quantities that would
make these products commercially viable. If we are unable to develop or
contract for manufacturing capabilities on acceptable terms for our products
under development, we will not be able to conduct pre-clinical and clinical
testing on these product candidates, which will prevent or delay regulatory
clearance or approval of these product candidates and the initiation of new
development programs. Our blood screening products must be manufactured in compliance with
guidelines set forth by the FDAs Center for Biologics Evaluation and Research,
and our clinical diagnostic products must be manufactured in compliance with
the guidelines set forth by the FDAs Center for Devices and Radiological
Health. Maintaining compliance with more than one division of the FDA adds
complexity and cost to our overall manufacturing processes. In addition, our
manufacturing facilities and those of our contract manufacturers are subject to
periodic regulatory inspections by the FDA and other federal and state
regulatory agencies, and these facilities are subject to Quality System
Regulations requirements of the FDA. We or our contractors may fail to satisfy
these regulatory requirements in the future, and any failure to do so may
prevent us from selling our products. We distribute instrument systems to be used by our customers in performing
our diagnostic assays. These instrument systems have a limited life and may
become obsolete over time. For example, our MultiProbe instruments that we have
placed with our customers are no longer supported by the manufacturer, and new
MultiProbe instruments, while available, are not suitable for our customers. In
the future, we intend to develop an instrument to replace the MultiProbe for
our lower volume customers. We continue to support our current MultiProbe
instruments through our own inventories of parts and used instruments. If we
are unable to develop or acquire new instrument systems to replace our existing
systems as they become obsolete, we may lose assay product sale revenues and
our business may suffer. Our products are subject to recalls even after receiving FDA approval or
clearance. The FDA and similar governmental authorities in other countries have the
authority to require the recall of our products if we fail to comply with
relevant regulations pertaining to laboratory practices, product manufacturing,
labeling, advertising, or promotional activities, or if new information is
obtained concerning the safety of a product. A government-mandated recall, or a
voluntary recall by us, could divert managerial and financial resources and
harm our reputation with customers. In the past, we have had four voluntary recalls. The first product recall
occurred in September 1999, when we responded to customer complaints about an
increase in the number of our Mycobacterium Tuberculosis Direct, or MTD, assays
demonstrating inhibition by test specimens. The formulation problem was
identified and corrected. The second recall occurred in February 2000 when we
recalled our MTD product due to decreased stability of a reagent in certain kit
lots. The problem was identified and rectified. The third recall occurred in
July 2002 following the discovery of an error in the Chiron Procleix System
software used with the Procleix HIV-1/HCV blood screening assay and
instruments. A review of prior test results determined that the defect did not
cause any inaccurate results. The problem was rectified in a subsequent
software update, which was submitted to and approved by the FDA. The fourth
voluntary recall occurred in June 2004 for our MTD product. This customer
notification by us was due to decreased stability of a reagent in certain kit
lots. The problem was identified and rectified through updated raw material
specifications. Our products may be subject to additional recalls in the
future and we may not be able to identify and correct the problems leading to
recalls in all circumstances. Our sales to international markets are subject to additional risks. Sales of our products outside the United States accounted for 14% of our
total revenues for the six months ended June 30, 2004 and 13% of our total
revenues for all of 2003. Sales by Chiron outside of the United States
accounted for 44% of our international revenues for the six months ended June
30, 2004 and 58% of our international revenues for all of 2003. Chiron has
responsibility for the international distribution of our blood screening
products, which includes sales in France, Australia, Singapore, New Zealand,
Italy and other countries. Our sales in France and Japan that were not made
through Chiron accounted for 12% and 7%, respectively, of our international
sales for the six months ended June 30, 2004 and 16% and 10%, respectively, for
all of 2003. We expect a significant portion of our sales growth, especially with
respect to our blood screening products, to come from expansion 27




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in international markets. Accordingly, we encounter risks inherent in
international operations. Other than Canada, our sales are currently
denominated in United States dollars, if the value of the United States dollar
increases relative to foreign currencies, our products could become less
competitive in international markets. Our international sales also may be
limited or disrupted by:  
    
    the imposition of government controls,
    
    export license requirements,
    
    economic and political instability,
    
    price controls,
    
    trade restrictions and tariffs,
    
    differing local product preferences and product requirements, and
    
    changes in foreign medical reimbursement and coverage policies and programs. In addition, we may have difficulty introducing new products in international
markets. For example, we do not believe our blood screening products will be
widely adopted in Germany until we are able to offer an assay that screens for
HBV, HAV, and parvo B19, as well as HIV-1 and HCV, or in Japan until we are
able to offer an assay that screens for HBV, HIV-1 and HCV. Whenever we seek to
enter a new international market, we will be dependent on the marketing and
sales efforts of our international distributors. We believe that the international markets for our products are important,
and therefore we seek patent protection for our products in foreign countries
where we feel such protection is needed. Because of the differences in foreign
patent and other laws concerning proprietary rights, our products may not
receive the same degree of protection in foreign countries as they would in the
United States. If third-party payors do not reimburse our customers for the use of our
products or reduce reimbursement levels, our ability to sell our products
profitably will be harmed. We sell our products primarily to large reference laboratories, public
health laboratories and hospitals. Large reference laboratories and hospitals
receive reimbursement for the health care services they provide to their
patients from third-party payors, such as Medicare, Medicaid and other domestic
and international government programs, standard state funding, private
insurance plans and managed care programs. Most of these third-party payors may
deny reimbursement if they determine that a medical product was not used in
accordance with cost-effective treatment methods, as determined by the
third-party payor, or was used for an unapproved indication. Third-party payors
also may refuse to reimburse for experimental procedures and devices. Third-party payors reimbursement policies also may affect sales of our
products that screen for more than one pathogen at the same time, such as our
APTIMA Combo 2 product for screening for the causative agents of chlamydial
infections and gonorrhea in the same sample. Third-party payors may choose to
reimburse our customers on a per test basis, rather than on the basis of the
number of results given by the test. This may result in laboratories and
hospitals electing to use separate tests to screen for each disease so that
they can receive reimbursement for each test they conduct. In that event,
laboratories and hospitals likely would purchase separate tests for each
disease, rather than our products that test for more than one microorganism. In addition, third-party payors are increasingly attempting to contain
health care costs by limiting both coverage and the level of reimbursement for
medical products and services. Levels of reimbursement may decrease in the
future, and future legislation, regulation or reimbursement policies of
third-party payors may adversely affect the demand for and price levels of our
products. If our customers are not reimbursed for our products, they may reduce
or discontinue purchases of our products, which would cause our revenues to
decline. Disruptions in the supply of raw materials from our single source suppliers,
including the Roche Molecular Biochemicals division of Roche Diagnostics
GmbH, which is an affiliate of one of our primary competitors, could result
in a significant disruption in sales and profitability. We purchase some key raw materials used in the manufacture of our products
from single-source suppliers. We may not be able to 28




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obtain supplies from replacement suppliers on a timely or cost-effective
basis. For example, our current supplier of key raw materials for our amplified
NAT assays, pursuant to a fixed-price contract, is the Roche Molecular
Biochemicals division of Roche Diagnostics GmbH, an affiliate of Roche
Molecular Systems, which is one of our primary competitors and the purchaser of
Boehringer-Mannheim GmbH, with whom we had originally contracted for supplies.
A reduction or stoppage in supply while we seek a replacement supplier would
limit our ability to manufacture our products, which could result in a
significant reduction in sales and profitability. In addition, an impurity or
variation in a raw material, either unknown to us or incompatible with our
products, could significantly reduce our ability to manufacture products. Our
inventories may not be adequate to meet our production needs during any
prolonged interruption of supply. We have products under development which, if
developed, may require us to enter into additional supplier arrangements.
Failure to obtain a supplier for our future products, if any, on commercially
reasonable terms, would prevent us from manufacturing our future products and
limit our growth. We are dependent on technologies we license, and if we fail to license new
technologies and rights to particular nucleic acid sequences for targeted
diseases in the future, we may be limited in our ability to develop new
products. We are dependent on licenses from third parties for some of our key
technologies. For example, our patented Transcription-Mediated Amplification
technology is based on technology we have licensed from Stanford University and
the chemiluminescence technology we use in our products is based on technology
licensed by us and our consolidated subsidiary, Molecular Light Technology
Limited, from the University of Wales College of Medicine. If our license with
respect to any of these technologies is terminated for any reason, we will not
be able to sell products that incorporate the technology. In addition, although
our research staff seeks to discover particular nucleic acid sequences for
targeted diseases, our ability to develop additional diagnostic tests for
diseases may depend on the ability of third parties to discover particular
sequences or markers and correlate them with disease, as well as the rate at
which such discoveries are made. Likewise, our ability to design products that
target these diseases may be based on our ability to obtain the necessary
rights from third parties who make any of these discoveries. In addition, there
are a finite number of diseases and conditions for which our NAT assays may be
economically viable. If we are unable to obtain access to new technologies or
the rights to particular sequences or markers necessary for additional
diagnostic products on commercially reasonable terms, we may be limited in our
ability to develop new diagnostic products. If we fail to attract, hire and retain qualified personnel, we may not be
able to design, develop, market or sell our products or successfully manage
our business. Competition for top management personnel is intense and we may not be able
to recruit and retain the personnel we need. The loss of any one of our
management personnel, particularly Henry L. Nordhoff, our Chairman, President
and Chief Executive Officer, or our inability to identify, attract, retain and
integrate additional qualified management personnel, could make it difficult
for us to manage our business successfully, attract new customers, retain
existing customers and pursue our strategic objectives. Although we have
employment agreements with our executive officers, we may be unable to retain
our existing management. We do not maintain key person life insurance for any
of our executive officers. Similarly, competition for skilled sales, marketing, research, product
development, engineering, and technical personnel is intense and we may not be
able to recruit and retain the personnel we need. The loss of the services of
any key sales, marketing, research, product development, engineering, and
technical personnel, or our inability to hire new personnel with the requisite
skills, could restrict our ability to develop new products or enhance existing
products in a timely manner, sell products to our customers or manage our
business effectively. We may not be able to hire or retain qualified personnel if we are unable
to offer competitive salaries and benefits, or if our stock does not perform
well. We may acquire other businesses or form joint ventures that could decrease
our profitability, dilute your ownership of us, increase our debt or cause us
to incur significant expense. As part of our business strategy, we intend to pursue acquisitions of
other complementary businesses and technology licensing arrangements. We also
intend to pursue strategic alliances that leverage our core technology and
industry experience to expand our product offerings and geographic presence. We
have limited experience with respect to acquiring other companies and with
respect to the formation of collaborations, strategic alliances and joint
ventures. If we make future acquisitions, we may not be able to integrate these
acquisitions successfully into our existing business and we could assume
unknown or contingent liabilities. Any future acquisitions by us also could
result in large and immediate write-offs or the incurrence of debt and
contingent liabilities, any of which could harm our operating results.
Integration of an acquired company also may require management resources that
otherwise would be available for 29




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ongoing development of our existing business. We may not identify or
complete these transactions in a timely manner, on a cost-effective basis, or
at all, and we may not realize the anticipated benefits of any acquisition,
technology license or strategic alliance. To finance any acquisitions, we may choose to issue shares of our common
stock as consideration, which would dilute your interest in us. If the price of
our equity is low or volatile, we may not be able to acquire other companies.
Alternatively, it may be necessary for us to raise additional funds through
public or private financings. Additional funds may not be available on terms
that are favorable to us and, in the case of equity financings, may result in
dilution to our stockholders. We and our customers are subject to various governmental regulations, and we
may incur significant expenses to comply with these regulations and develop
products compatible with these regulations. The clinical diagnostic and blood screening products we design, develop,
manufacture and market are subject to rigorous regulation by the FDA and
numerous other federal, state and foreign governmental authorities. The process
of obtaining regulatory approvals, particularly from the FDA and some foreign
governmental authorities, to market our products can be costly and time
consuming, and approvals might not be granted for future products on a timely
basis, if at all. For example, we were prohibited from commercially marketing
our blood screening products in the United States until we obtained approval of
our Biologics License Application from the FDAs Center for Biologic Evaluation
and Research. We generally are prohibited from marketing our clinical
diagnostic products in the United States unless we obtain either 510(k)
clearance or premarket approval from the FDA. Delays in receipt of, or failure
to obtain, clearances or approvals for future products could result in delayed,
or no, realization of product revenues from new products or in substantial
additional costs which could decrease our profitability. In addition, we are required to continue to comply with applicable FDA and
other material regulatory requirements once we have obtained clearance or
approval for a product. These requirements include, among other things, the
Quality System Regulation, labeling requirements, the FDAs general prohibition
against promoting products for unapproved or off-label uses and adverse event
reporting regulations. Failure to comply with applicable FDA product regulatory
requirements could result in, among other things, warning letters, fines,
injunctions, civil penalties, repairs, replacements, refunds, recalls or
seizures of products, total or partial suspension of production, the FDAs
refusal to grant future premarket clearances or approvals, withdrawals or
suspensions of current product applications and criminal prosecution. Any of
these actions, in combination or alone, could prevent us from selling our
products. Outside the United States, our ability to market our products is
contingent upon receiving marketing authorization from the appropriate
regulatory authorities. The requirements governing the conduct of clinical
trials, marketing authorization, pricing and reimbursement vary widely from
country to country. At present, we apply for foreign marketing authorizations
at a national level, although within the European Union, registration
procedures are available to companies wishing to market a product in more than
one European union member state. We are currently taking action to have our
products registered for sale into the European Economic Community following a
new requirement that becomes effective in December 2004. Failure to receive, or
delays in the receipt of, relevant foreign qualifications could prevent us from
selling our products in foreign countries. As both the FDA and foreign government regulators have become increasingly
stringent, we may be subject to more rigorous regulation by governmental
authorities in the future. Our products and operations also are often subject
to the rules of industrial standards bodies, such as the International
Standards Organization. Complying with these rules and regulations could cause
us to incur significant additional expenses, which would harm our operating
results. The use of our diagnostic products is also affected by the Clinical
Laboratory Improvement Amendments of 1988, or CLIA, and related federal and
state regulations which provide for regulation of laboratory testing. CLIA is
intended to ensure the quality and reliability of clinical laboratories in the
United States by mandating specific standards in the areas of personnel
qualifications, administration, participation in proficiency testing, patient
test management, quality and inspections. Current or future CLIA requirements
or the promulgation of additional regulations affecting laboratory testing may
prevent some clinical laboratories from using any or all of our diagnostic
products. If a natural or man-made disaster strikes our manufacturing facilities, we
will be unable to manufacture our products for a substantial amount of time
and our sales will decline. We manufacture all of our products in our two manufacturing facilities
located in San Diego, California. These facilities and the manufacturing
equipment we use to produce our products would be costly to replace and could
require substantial lead time to repair or replace. The facilities may be
harmed by natural or man-made disasters, including, without limitation,
earthquakes and fires, and in the event they were affected by a disaster, we
would be forced to rely on third-party manufacturers. In the event of a
disaster, we may lose 30




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customers and we may be unable to regain those customers thereafter.
Although we possess insurance for damage to our property and the disruption of
our business from casualties, this insurance may not be sufficient to cover all
of our potential losses and may not continue to be available to us on
acceptable terms, or at all. If we use biological and hazardous materials in a manner that causes injury
or violates laws, we may be liable for damages. Our research and development activities and our manufacturing activities
involve the controlled use of potentially harmful biological materials as well
as hazardous materials, chemicals and various radioactive compounds. We cannot
completely eliminate the risk of accidental contamination or injury, and we
could be held liable for damages that result from such contamination or injury.
In addition, we are subject to federal, state and local laws and regulations
governing the use, storage, handling and disposal of these materials and
specified waste products. The damages resulting from any accidental
contamination and the cost of compliance with environmental laws and
regulations could be significant. The anti-takeover provisions of our certificate of incorporation and by-laws,
provisions of Delaware law and our rights plan could delay or prevent a
change of control that you may favor. Provisions of our 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 our common stock to change our management. The
provisions of our amended and restated certificate of incorporation and amended
and restated bylaws, among other things:  
    
    divide our board of directors into three classes, with members of each class to be elected for staggered three-year terms,
    
    limit the right of stockholders to remove directors,
    
    regulate how stockholders may present proposals or nominate directors for election at annual meetings of stockholders, and
    
    authorize our board of directors to issue preferred stock in one or more series, without stockholder approval. In addition, because we have 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 may favor. Section 203 provides that, subject to
limited exceptions, persons that acquire, or are affiliated with a person that
acquires, more than 15% 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% stock ownership threshold. We also adopted a rights plan that could discourage, delay or prevent an
acquisition of us under certain circumstances. The rights plan provides for
preferred stock purchase rights attached to each share of our common stock,
which will cause substantial dilution to a person or group acquiring 15% or
more of our stock if the acquisition is not approved by our Board of Directors. On May 28, 2004, our stockholders approved an amendment to our Amended and
Restated Certificate of Incorporation to increase our authorized number of
shares of common stock from 100,000,000 shares to 200,000,000 shares. The
additional shares of common stock may be used for various purposes without
further stockholder approval. These purposes may include: effecting additional
stock dividends; raising capital; providing equity incentives to employees,
officers or directors; establishing strategic relationships with other
companies; expanding the companys business or product lines through the
acquisition of other businesses or products; and other purposes. Although the
increase in the authorized common stock was prompted by business and financial
consideration and not by the threat of any hostile takeover attempt (nor is the
Board currently aware of any such attempts directed as us), nevertheless, the
availability of these shares could facilitate future efforts by us to deter or
prevent changes in control, including transactions in which our stockholders
might otherwise receive a premium for their shares over then current market
prices. We may not successfully integrate acquired businesses. In August 2003, we acquired a majority of the outstanding shares of
Molecular Light Technology Limited and its subsidiaries and in the future, we
may acquire additional businesses or technologies, or enter into strategic
transactions. Managing these acquisitions and any future acquisitions will
entail numerous operational and financial risks, including:  
    
    the inability to retain key employees of any acquired businesses or
hire enough qualified personnel to staff any new or 31




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expanded operations;
    
    the impairment of relationships with key customers of acquired
businesses due to changes in management and ownership of the acquired
businesses;
    
    the exposure to federal, state, local and foreign tax liabilities in
connection with any acquisition or the integration of any acquired
businesses;
    
    the exposure to unknown liabilities;
    
    higher than expected acquisition and integration costs that would
cause our quarterly and annual operating results to fluctuate;
    
    increased amortization expenses if an acquisition results in significant goodwill or other intangible assets;
    
    combining the operations and personnel of acquired businesses with our own, which would be difficult and costly; and
    
    integrating or completing the development and application of any
acquired technologies, which would disrupt our business and divert our
managements time and attention. If we do not effectively manage our growth, it could affect our ability to
pursue opportunities and expand our business. Growth in our business has placed and may continue to place a significant
strain on our personnel, facilities, management systems and resources. We will
need to continue to improve our operational and financial systems and
managerial controls and procedures and train and manage our workforce. We will
have to maintain close coordination among our various departments. If we fail
to effectively manage our growth and address the foregoing concerns, it could
adversely affect our ability to pursue business opportunities and expand our
business. Future changes in financial accounting standards or practices or existing
taxation rules or practices may cause adverse unexpected financial reporting
fluctuations and affect our reported results of operations. A change in accounting standards or practices or a change in existing
taxation rules or practices can have a significant effect on our reported
results and may even affect our reporting of transactions completed before the
change is effective. New accounting pronouncements and taxation rules and
varying interpretations of accounting pronouncements and taxation practice have
occurred and may occur in the future. Changes to existing rules or the
questioning of current practices may adversely affect our reported financial
results or the way we conduct our business. For example, any changes requiring
that we record compensation expense in the statement of operations for employee
stock options using the fair value method or changes in existing taxation rules
related to stock options could have a significant negative effect on our
reported results. Several agencies and entities are considering, and the
Financial Accounting Standards Board has announced, proposals to change
generally accepted accounting principles in the United States that, if
implemented, would require us to record charges to earnings for employee stock
option grants. This pending requirement would negatively impact our earnings.
For example, recording a charge for employee stock options under SFAS No. 123,
Accounting for Stock-Based Compensation, would have reduced our net income by
$2.4 million and $0.2 million for the three months ended June 30, 2004 and
2003, and $4.3 million and $0.4 million for the six months ended June 30, 2004
and 2003, respectively. Systems implementation issues could disrupt our internal operations and
adversely affect our financial results. Portions of our information technology infrastructure may experience
interruptions, delays or cessations of service or produce errors in connection
with ongoing systems implementation work. In particular, we plan to implement a
new general ledger information system and data warehouse to replace our current
systems over the next two years. As a part of this effort, we are rationalizing
various legacy systems and upgrading existing hardware and software
applications and implementing new data management applications to administer
our business information. We may not be successful in implementing the new
system, and transitioning data and other aspects of the process could be more
expensive, time consuming and resource intensive than planned. Any disruptions
that may occur in the implementation of this new system or any future systems
could increase our expenses and adversely affect our ability to report in an
accurate and timely manner the results of our consolidated operations, our
financial position and cash flow and to otherwise operate our business, which
could adversely affect our financial results, stock price and reputation. 32




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Compliance with changing corporate governance and public disclosure
regulations may result in additional expenses. Changing laws, regulations and standards relating to corporate governance
and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC
regulations and Nasdaq Stock Market rules, are creating uncertainty for
companies such as ours. To maintain high standards of corporate governance and
public disclosure, we intend to invest all reasonably necessary resources to
comply with evolving standards. These investments may result in increased
general and administrative expenses and a diversion of management time and
attention from revenue-generating activities. Available Information Copies of our public filings are available on our Internet website at
http://www.gen-probe.com as soon as reasonably practicable after we
electronically file such material with, or furnish them to, the SEC. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk Our exposure to market risk for changes in interest rates relates
primarily to the increase or decrease in the amount of interest income we can
earn on our investment portfolio. Our risk associated with fluctuating interest
income is limited to our investments in interest rate sensitive financial
instruments. Under our current policies, we do not use interest rate derivative
instruments to manage this exposure to interest rate changes. We seek to ensure
the safety and preservation of our invested principal by limiting default risk,
market risk, and reinvestment risk. We mitigate default risk by investing in
short-term investment grade securities. A hypothetical 100 basis point adverse
move in interest rates along the entire interest rate yield curve would not
materially affect the fair value of our financial instruments that are exposed
to changes in interest rates. We are exposed to foreign exchange risk for expenditures in certain
foreign countries, but the total receivables and payables denominated in
foreign currencies at June 30, 2004 were not material. We believe that our
business operations are not exposed to market risk relating to commodity price
risk. 
 Item 4. Controls and Procedures As of the end of the period covered by this Quarterly Report on Form 10-Q,
we carried out an evaluation, under the supervision and with the participation
of our management, including our Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended. Based on this evaluation, our
Chief Executive Officer and Chief Financial Officer concluded that our
disclosure controls and procedures were effective as of the end of the quarter
ended June 30, 2004. An evaluation was also performed under the supervision and with the
participation of our management, including our Chief Executive Officer and
Chief Financial Officer, of any change in our internal control over financial
reporting that occurred during our last fiscal quarter and that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting. That evaluation did not identify any change in our
internal control over financial reporting that occurred during our latest
fiscal quarter and that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. We maintain disclosure controls and procedures that are designed to ensure
that information required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the SECs rules and forms, and that such information is accumulated and
communicated to our management, including our 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 and not absolute assurance
of achieving the desired control objectives. 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.
In addition, the design of any system of controls also is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions; over time, control may become inadequate because
of changes in conditions, or the degree of compliance with policies or
procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur
and not be detected. 33




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings A description of our material pending legal proceedings is disclosed in
Note 9 (Litigation) of the Notes to Condensed Consolidated Financial
Statements included in Item 1 of Part I of this report and is incorporated by
reference herein. See Notes to Condensed Consolidated Financial Statement 
Note 9  Litigation. We are also engaged in other legal actions arising in the
ordinary course of our business and believe that the ultimate outcome of these
actions will not have a material adverse effect on our business, financial
condition or results of operations. However, due to the uncertainties inherent
in litigation, no assurance can be given as to the outcome of these
proceedings. If any of these matters were resolved in a manner unfavorable to
us, our business, financial condition and results of operations would be
harmed. 
 Item 4. Submission of Matters to a Vote of Security Holders On May 28, 2004, our Annual Meeting of Stockholders was held in San Diego,
California for the following purposes:  (1)
    
    To elect three (3) directors to hold office until the 2007 Annual
Meeting of Stockholders. For Mae C. Jemison, M.D., the number of votes were as follows:For: 39,666,939Withheld: 1,369,492For Brian A. McNamee, M.B.B.S., the number of votes were as follows:For: 39,683,312Withheld: 1,353,119For Armin M. Kessler, the number of votes were as follows:For: 39,679,987Withheld: 1,356,444
  (2)
    
    To approve an amendment to our Amended and Restated Certificate of
Incorporation to increase the authorized number of shares of common stock
from 100,000,000 to 200,000,000 shares. The number of votes were as
follows: For: 34,650,773Against: 6,352,917Abstaining: 17,813Broker Non-votes: 14,928
  (3)
    
    To ratify the selection by the Audit Committee of our Board of
Directors of Ernst &Young LLP as our independent auditors for the fiscal
year ending December 31, 2004. The number of votes were as follows: For: 40,354,192Against: 646,485Abstaining: 20,826Broker Non-Votes: 14,928
 
 Item 6. Exhibits and Report on Form 8-K 34




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(a)
    
    Exhibits ExhibitNumber
    
    Description3.1(1)
    
    Amended and Restated Certificate of Incorporation of Gen-Probe Incorporated.3.2(1)
    
    Amended and Restated Bylaws of Gen-Probe Incorporated.3.3
    
    Certificate of Amendment of Amended and Restated Certificate of
Incorporation of Gen-Probe Incorporated.3.4
    
    Certificate of Designations of the Series A Junior Participating Preferred
Stock of Gen-Probe Incorporated.4.1(1)
    
    Specimen common stock certificate.4.2(2)
    
    Rights Agreement, dated as of September 16, 2002, between Gen-Probe
Incorporated and Mellon Investor Services LLC, which includes the
form of Certificate of Designations of the Series A Junior Participating Preferred
Stock of Gen-Probe Incorporated as Exhibit A, the form of Right Certificate
as Exhibit B and the Summary of Rights to Purchase Preferred Shares as
Exhibit C.4.4(3)
    
    First Amendment to Rights Agreement, dated October 9, 2002, between
Gen-Probe Incorporated and Mellon Investor Services LLC.4.5(4)
    
    Second Amendment to Rights Agreement, dated November 20, 2003.10.71
    
    Employee Stock Purchase Plan.10.72
    
    2003 Amendment to the Renewed Distribution Agreement and the
Distributorship Arrangements Agreement dated May 2, 1997, entered into May
2, 2003 by and between Gen-Probe Incorporated and bioMerieux, S.A.*10.73
    
    Supply Agreement entered into January 1, 2002 by and between Gen-Probe
Incorporated and MGM Instruments, Inc.*10.74
    
    Supply Agreement Amendment Number One entered into June 4, 2004 by and
between Gen-Probe Incorporated and MGM Instruments, Inc.*31.1
    
    Certification dated August 9, 2004, of Principal Executive Officer required
pursuant to 18 USC. Section 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.31.2
    
    Certification dated August 9, 2004, of Principal Financial Officer required
pursuant to 18 USC. Section 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    
    Certification dated August 9, 2004, of Principal Executive Officer required
pursuant to 18 USC. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification dated August 9, 2004, of Principal Financial Officer required
pursuant to 18 USC. Section 1350, as adopted pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.
   
    
    Filed herewith. 35




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(1)
    
    Incorporated by reference to Gen-Probes Amendment No. 2 to Registration
Statement on Form 10 filed with the SEC on August 14, 2002.(2)
    
    Incorporated by reference to Gen-Probes Report on Form 8-K filed with
the SEC on September 17, 2002.(3)
    
    Incorporated by reference to Gen-Probes Quarterly Report on Form 10-Q
filed with the SEC on November 14, 2002.(4)
    
    Incorporated by reference to Gen-Probes Report on Form 8-K filed with
the SEC on November 21, 2003.*
    
    Gen-Probe has requested confidential treatment with respect to certain
portions of this exhibit. The confidential portions of this exhibit are
marked by an asterisk and have been omitted and filed separately with the
SEC pursuant to Gen-Probes request for confidential treatment.  (b)
    
    Reports on Form 8-KOn May 3, 2004, we filed a report on Form 8-K dated May 3, 2004 relating to
the results of our fiscal quarter ended March 31, 2004. Under the Form 8-K,
we furnished (not filed) pursuant to Item 12 under Item 7 the press release
entitled Gen-Probe Reports Strong Financial Results for First Quarter 2004,
Raises Full-Year Guidance relating to the results of our fiscal quarter
ended March 31, 2004. 36




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SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. DATE: August 9, 2004
    By:
    /s/ Henry L. NordhoffHenry L. NordhoffChairman, President and Chief Executive Officer
(Principal Executive Officer) DATE: August 9, 2004
    By:
    /s/ Herm RosenmanHerm RosenmanVice President - Finance and Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer) 37