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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 
 FORM 10-Q (Mark One)[X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 OR [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For
the transition period from _______ to _______ Commission file number 000-31167 Genencor International, Inc. (Exact name of registrant as specified in its charter)
 
 Delaware
(State or other jurisdiction of
incorporation or organization)
    
    16-1362385
(I.R.S. Employer
Identification Number)
 925 Page Mill Road
Palo Alto, California 94304
(650) 846-7500
(Address, including zip code, and telephone number, including area code, of registrants principal executive offices)   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or15(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 report(s), and (2) has been subject to
such filing requirements for the past 90 days Yes [ X ] No [ ]
 Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ X ] No [ ]
 
 Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date. Class
    
    Number of Shares Outstanding at April 30, 2004Common stock, par value $0.01 per share
    
    
    59,322,668




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TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATIONItem 1. Financial Statements:Condensed Consolidated Unaudited Balance Sheets as of March 31, 2004 and December 31, 2003
    
    
    4Condensed Consolidated Unaudited Statements of Operations for the three months ended
March 31, 2004 and 2003
    
    
    5Condensed Consolidated Unaudited Statements of Cash Flows for the three months ended
March 31, 2004 and 2003
    
    
    6Notes to Condensed Consolidated Unaudited Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    24Item 4. Controls and Procedures
    
    
    24PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    24Item 2. Change in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    24Item 3. Defaults Upon Senior Securities
    
    
    24Item 4. Submission of Matters to a Vote of Security Holders
    
    
    25Item 5. Other Information
    
    
    25Item 6. Exhibits and Reports on Form 8-K
    
    
    25SIGNATURES
    
    
    26INDEX to EXHIBITS
    
    
    27EX-2.1 TRANSFER AGREEMENTEX-10.1 RESEARCH AGREEMENTEX-31.1 Rule 13a-14(a)/15d-14(a) CertificationsEX-31.2 Rule 13a-14/15d-14(a) CertificationsEX-32.1 Section 1350 Certifications
  2




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Unless otherwise specified, all references to the Company, we, us,
our, and ourselves refer to Genencor International, Inc. or Genencor
International, Inc. and its subsidiaries collectively, as appropriate in the
context of the disclosure. This Report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, as amended. These include statements concerning plans,
objectives, goals, strategies, future events or performance and all other
statements which are other than statements of historical fact, including
without limitation, statements containing the words believes, anticipates,
expects, estimates, intends, plans, projects, will, may, might,
and words of a similar nature. The forward-looking statements contained in
this Report reflect the Companys current beliefs and expectations on the date
of this Report. Actual results, performance or outcomes may differ materially
from those expressed in the forward-looking statements. Some of the
important factors which, in the view of the Company, could cause actual results
to differ from those expressed in the forward-looking statements are discussed
in Part I, Item 2 of this Report and in the Companys Annual Report on Form
10-K for the year ended December 31, 2003. The Company disclaims any obligation
to update any forward-looking statement to reflect facts or circumstances after
the date hereof. 3




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements GENENCOR INTERNATIONAL, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED UNAUDITED BALANCE SHEETS
(Amounts in thousands, except per share data) March 31,
    
    December 31,2004
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    139,452
    
    
    $
    166,551Trade accounts receivable, net
    
    
    59,803
    
    
    
    58,249Inventories
    
    
    70,234
    
    
    
    64,159Other current assets
    
    
    36,961
    
    
    
    36,253Total current assets
    
    
    306,450
    
    
    
    325,212Property, plant and equipment, net
    
    
    227,008
    
    
    
    232,902Goodwill
    
    
    29,379
    
    
    
    29,380Intangible assets, net
    
    
    45,346
    
    
    
    47,075Other assets
    
    
    78,521
    
    
    
    77,853Total assets
    
    $
    686,704
    
    
    $
    712,422Liabilities, Redeemable Preferred Stock and Stockholders EquityCurrent liabilities:Notes payable
    
    $
    5,926
    
    
    $
    5,926Current maturities of long-term debt
    
    
    28,249
    
    
    
    28,249Accounts payable and accrued expenses
    
    
    47,664
    
    
    
    49,143Other current liabilities
    
    
    13,323
    
    
    
    18,850Total current liabilities
    
    
    95,162
    
    
    
    102,168Long-term debt
    
    
    30,395
    
    
    
    58,466Other long-term liabilities
    
    
    38,521
    
    
    
    39,101Total liabilities
    
    
    164,078
    
    
    
    199,735Redeemable preferred stock:7 1/2% cumulative series A preferred stock, without par value, authorized
1 shares, 1 shares issued and outstanding
    
    
    178,844
    
    
    
    177,025Stockholders equity:Common stock, par value $0.01 per share, 200,000 shares
authorized, 61,091 and 60,991 shares issued at
March 31, 2004 and December 31, 2003, respectively
    
    
    611
    
    
    
    610Additional paid-in capital
    
    
    360,526
    
    
    
    359,344Treasury stock, 1,780 shares at cost at March 31, 2004 and
December 31, 2003
    
    
    (21,030
    )
    
    
    (21,030
    )Deferred stock-based compensation
    
    
    (913
    )
    
    
    (1,036
    )Retained earnings
    
    
    11,779
    
    
    
    589Accumulated other comprehensive loss
    
    
    (7,191
    )
    
    
    (2,815
    )Total stockholders equity
    
    
    343,782
    
    
    
    335,662Total liabilities, redeemable preferred stock and stockholders equity
    
    $
    686,704
    
    
    $
    712,422
 The accompanying notes are an integral part of the condensed consolidated unaudited financial statements. 4




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GENENCOR INTERNATIONAL, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED UNAUDITED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data) Three months endedMarch 31,2004
    
    2003Revenues:Product revenue
    
    $
    91,539
    
    
    $
    90,038Fees and royalty revenues
    
    
    2,824
    
    
    
    5,623Total revenues
    
    
    94,363
    
    
    
    95,661Operating expenses:Cost of products sold
    
    
    50,465
    
    
    
    50,841Research and development
    
    
    16,880
    
    
    
    16,460Sales, marketing and business development
    
    
    8,320
    
    
    
    7,699General and administrative
    
    
    8,502
    
    
    
    7,801Amortization of intangible assets
    
    
    1,175
    
    
    
    1,392Other (income)/expense
    
    
    (7,905
    )
    
    
    705Total operating expenses
    
    
    77,437
    
    
    
    84,898Operating income
    
    
    16,926
    
    
    
    10,763Non operating expenses/(income):Interest expense
    
    
    1,536
    
    
    
    2,020Interest income
    
    
    (871
    )
    
    
    (845
    )Total non operating expense/(income)
    
    
    665
    
    
    
    1,175Income before income taxes
    
    
    16,261
    
    
    
    9,588Provision for income taxes
    
    
    3,252
    
    
    
    3,068Net income
    
    $
    13,009
    
    
    $
    6,520Net income available to holders of
common stock
    
    $
    11,190
    
    
    $
    4,701Earnings per common share:Basic
    
    $
    0.19
    
    
    $
    0.08Diluted
    
    $
    0.18
    
    
    $
    0.08Weighted average common shares:Basic
    
    
    59,266
    
    
    
    58,499Diluted
    
    
    61,275
    
    
    
    58,799
 The accompanying notes are an integral part of the condensed consolidated unaudited financial statements. 5




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GENENCOR INTERNATIONAL, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED UNAUDITED STATEMENTS OF CASH FLOWS
(Amounts in thousands) Three months endedMarch 31,2004
    
    2003Cash flows from operating activities:Net income
    
    $
    13,009
    
    
    $
    6,520Adjustments to reconcile net income to net
cash provided by operating activities:Depreciation and amortization
    
    
    9,084
    
    
    
    8,760Amortization of deferred stock-based
compensation
    
    
    123
    
    
    
    299(Increase) decrease in operating assets:Trade accounts receivable
    
    
    (2,193
    )
    
    
    (7,875
    )Inventories
    
    
    (6,774
    )
    
    
    (1,569
    )Other assets
    
    
    5,930
    
    
    
    248Decrease in operating liabilities:Accounts payable and accrued expenses
    
    
    (3,941
    )
    
    
    (3,173
    )Other liabilities
    
    
    (8,936
    )
    
    
    (3,431
    )Net cash provided by/(used in)
operating activities
    
    
    6,302
    
    
    
    (221
    )Cash flows from investing activities:Purchases of property, plant and equipment
    
    
    (3,721
    )
    
    
    (4,548
    )Proceeds from note receivable
    
    
    125
    
    
    
    Payments related to prior acquisition
    
    
    (632
    )
    
    
    Net cash used in investing activities
    
    
    (4,228
    )
    
    
    (4,548
    )Cash flows from financing activities:Proceeds from exercise of stock options
    
    
    345
    
    
    
    164Proceeds from employee stock purchase plan
    
    
    402
    
    
    
    345Proceeds from notes of foreign
affiliate
    
    
    
    
    
    
    91Payment of long-term debt
    
    
    (28,063
    )
    
    
    (28,061
    )Net cash used in financing activities
    
    
    (27,316
    )
    
    
    (27,461
    )Effect of exchange rate changes on cash
    
    
    (1,857
    )
    
    
    1,915Net decrease in cash and cash equivalents
    
    
    (27,099
    )
    
    
    (30,315
    )Cash and cash equivalents  beginning of period
    
    
    166,551
    
    
    
    169,001Cash and cash equivalents  end of period
    
    $
    139,452
    
    
    $
    138,686
 The accompanying notes are an integral part of the condensed consolidated unaudited financial statements. 6




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GENENCOR INTERNATIONAL, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
(Amounts in thousands, except per share data) 1  Basis of Presentation The condensed consolidated unaudited financial statements should be read
in conjunction with the Companys audited consolidated financial statements and
related footnotes for the year ended December 31, 2003, as included in the
Companys Annual Report on Form 10-K. These interim financial statements have
been prepared in conformity with the rules and regulations of the U.S.
Securities and Exchange Commission. Certain disclosures normally included in
financial statements prepared in conformity with accounting principles
generally accepted in the United States of America have been condensed or
omitted pursuant to such rules and regulations pertaining to interim financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring adjustments) necessary for fair presentation of the interim financial
statements have been included therein. The results of operations of any interim
period are not necessarily indicative of the results of operations for the full
year. 2  New Accounting Pronouncements In December 2003, the Financial Accounting Standards Board (FASB) issued
a revision of Statement of Financial Accounting Standards (SFAS) No. 132,
Employers Disclosures about Pensions and Other Postretirement Benefits. The
revised Statement provides required disclosures for pensions and other
postretirement benefit plans and is designed to improve disclosure transparency
in financial statements. The revised Statement replaces existing year-end and
interim disclosure requirements. This Statement was in effect for the
Companys fiscal year ending December 31, 2003 and for quarters beginning
thereafter for domestic plans, and will be effective for fiscal years ending
after June 15, 2004 for the Companys foreign plans. In January 2004, the FASB issued FASB Staff Position No. FAS 106-1,
Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003. This Position permits
employers that sponsor postretirement benefit plans that provide prescription
drug benefits to retirees to make a one-time election to defer accounting for
any effects of the Medicare Prescription Drug, Improvement and Modernization
Act of 2003 (Act). Specific authoritative guidance on the accounting for the
federal subsidy is pending and that guidance, when issued, could require the
sponsor of such a plan to change previously reported information. The
Companys financial statements do not reflect any implications of the Act due
to the level of uncertainty about the forthcoming guidance. 3  Pension Plans A
summary of the components of net periodic pension cost, a non-cash item,
for the three months ended March 31 is as follows: 2004
    
    2003Service Cost
    
    $
    773
    
    
    $
    701Interest Cost
    
    
    231
    
    
    
    204Expected return on plan assets
    
    
    (272
    )
    
    
    (179
    )Net amortization
    
    
    38
    
    
    
    51Net periodic pension cost
    
    $
    770
    
    
    $
    777
 7




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4  Earnings Per Share SFAS No. 128, Earnings per Share, requires the disclosure of basic and
diluted earnings per share. Basic earnings per share is computed based on the
weighted average number of common shares outstanding during the period. In
arriving at net income available to holders of common stock, undeclared and
unpaid dividends on redeemable preferred stock of $1,819 were deducted from net
income for each quarter presented. Diluted earnings per common share reflects the potential dilution that
could occur if dilutive securities and other contracts to issue common stock
were exercised or converted into common stock or resulted in the issuance of
common stock that then shared in the net income available to holders of common
stock of the Company. As a result of stock options outstanding under the
Companys 2002 Omnibus Incentive Plan and its predecessor plan, the
Companys Stock Option and Stock Appreciation Right Plan, there were dilutive
securities for the three months ended March 31, 2004 and 2003. The
weighted-average impact of these has been reflected in the calculation of
diluted earnings per common share for the respective periods presented. The following table reflects the calculation of basic and diluted earnings
per common share for the three months ended March 31: 2004
    
    2003Net income
    
    $
    13,009
    
    
    $
    6,520Less: Accrued dividends on preferred stock
    
    
    (1,819
    )
    
    
    (1,819
    )Net income available to holders
of common stock
    
    $
    11,190
    
    
    $
    4,701Weighted average common shares:Basic
    
    
    59,266
    
    
    
    58,499Effect of stock options
    
    
    2,009
    
    
    
    300Diluted
    
    
    61,275
    
    
    
    58,799Earnings per common share:Basic
    
    $
    0.19
    
    
    $
    0.08Diluted
    
    $
    0.18
    
    
    $
    0.08
 5  Stock-Based Compensation The Company adopted the provisions of SFAS No. 148. The Company uses the
intrinsic value method to account for stock-based employee compensation in
accordance with Accounting Principles Board (APB) Opinion No. 25 Accounting
for Stock Issued to Employees. 8




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On a pro forma basis, had compensation cost for the Companys stock option
plans been determined based on the weighted average fair value at the grant
date, the Companys net income and earnings per share would have been reduced
to the pro forma amounts shown below: Three Months EndedMarch 31,2004
    
    2003Net income available to holders of
common stock, as reported
    
    $
    11,190
    
    
    $
    4,701Add: Stock-based employee compensation expense
included in reported net income available,
net of related tax
    
    
    
    
    
    
    162Deduct: Total stock-based employee compensation
expense determined under fair value based method for
all awards, net of related tax effect
    
    
    (1,498
    )
    
    
    (1,300
    )Pro forma
net income available to holders of common stock
    
    $
    9,692
    
    
    $
    3,563Earnings per common share:Basic  as reported
    
    $
    0.19
    
    
    $
    0.08Basic  pro forma
    
    $
    0.16
    
    
    $
    0.06Diluted  as reported
    
    $
    0.18
    
    
    $
    0.08Diluted  pro forma
    
    $
    0.16
    
    
    $
    0.06
 The pro forma figures in the preceding table may not be representative of
pro forma amounts in future quarters. 6  Inventories Inventories consist of the following: March 31,
    
    December 31,2004
    
    2003Raw materials
    
    $
    7,990
    
    
    $
    7,682Work-in-progress
    
    
    10,738
    
    
    
    9,106Finished goods
    
    
    51,506
    
    
    
    47,371Inventories
    
    $
    70,234
    
    
    $
    64,159
 The Company sustained damage to its finished
bioproducts inventory in the second quarter of 2003 as a result of an accident
in a third party warehouse in Rotterdam, the Netherlands. At the end of the
first quarter of 2004, the Company reached a final settlement of its
accident-related claim with its insurer totaling approximately $21,000. This
final settlement resulted in a net gain of $8,290 for the quarter. Of the
total settlement, Genencor has received cash payments of approximately $9,350
from its insurer through March 31, 2004. 7  Goodwill and Other Intangible Assets In accordance with the provisions of SFAS No. 142, the Company
does not amortize goodwill or other intangible assets
with indefinite useful lives. The Company has identified such other
indefinite-lived intangible assets to include certain previously acquired
technology. The Company periodically evaluates its indefinite-lived
intangible assets for impairment in accordance with the provisions of SFAS No.
142. The Company also has other intangible assets, such as patents, licenses,
and customer lists, which will continue to be amortized using the straight-line
method. These assets are expected to have no residual value once they are
fully amortized. 9




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The following table summarizes the changes in each major class of
intangible assets from January 1, 2004 through March 31, 2004: Intangible AssetsOtherAmortizableTechnology
    
    Assets
    
    Total
    
    GoodwillBalances, January 1,
2004
    
    $
    15,831
    
    
    $
    73,591
    
    
    $
    89,422
    
    
    $
    29,380Foreign currency translation
and other
adjustments
    
    
    (4
    )
    
    
    (792
    )
    
    
    (796
    )
    
    
    (1
    )Balances, March 31,
2004
    
    $
    15,827
    
    
    
    72,799
    
    
    
    88,626
    
    
    $
    29,379Less: Accumulated
amortization
    
    
    
    
    
    
    (43,280
    )
    
    
    (43,280
    )Intangible assets,
net
    
    
    
    
    
    $
    29,519
    
    
    $
    45,346
 Estimated fiscal year amortization expense is as follows: 2004
    
    $
    4,6002005
    
    
    4,1002006
    
    
    3,8002007
    
    
    2,5002008
    
    
    1,300
 8 Stockholders Equity Accumulated other comprehensive loss consists of the following: Foreign
    
    Marketable
    
    AccumulatedCurrency
    
    Securities
    
    OtherTranslation
    
    Valuation
    
    ComprehensiveAdjustment
    
    Adjustment
    
    LossBalances, December 31, 2003
    
    $
    (2,350
    )
    
    $
    (465
    )
    
    $
    (2,815
    )Current period change
    
    
    (4,926
    )
    
    
    550
    
    
    
    (4,376
    )Balances, March 31, 2004
    
    $
    (7,276
    )
    
    $
    85
    
    
    $
    (7,191
    )
 The change in the marketable securities valuation adjustment for the three
months ended March 31, 2004 of $550 ($873 pre-tax) relates to unrealized
holding gains on the Companys available-for-sale securities. 9  Income Taxes The effective income tax rate for the three months ended March 31, 2004
was 20% compared to 32% for the three months ended March 31, 2003, which
reflects the Companys assessment of its annual effective income tax rate.
Factors affecting the Companys estimated annual effective income tax rate
include increased research and development expenditures in the United States,
the statutory income tax rates and mix of earnings among tax jurisdictions,
amortization of certain intangible assets and other items which are not
deductible for tax purposes, and research and experimentation tax credits. In
addition, the estimated annual effective rate in the three months ended March
31, 2003 included the effect of estimated valuation allowances, since the
Company did not anticipate having the ability to utilize certain tax credits. 10




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10  Fees and Royalty Revenues The decrease in fees and royalty revenues of $2,799 for the three months
ended March 31, 2004 from the three months ended March 31, 2003 was primarily
due to the completion of the initial stages of our strategic alliance for the
development of new biomaterials with the Dow Corning Corporation. 11  Segment Reporting In
accordance with SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, segments were determined based on products
and services provided by each segment. Accounting policies for the segments
are the same as those described in Note 1, Summary of Significant Accounting
Policies of the Companys Annual Report on Form 10-K for the year ended
December 31, 2003. Performance of the segments is evaluated based on operating
income of the segment. No items below operating income are allocated to the
segments. The Company accounts for transactions, if any, between the segments
as though they were transactions with third parties at approximate market
prices. There were no material inter-segment transactions in the periods
presented. The Companys managerial financial reporting reflects two operating
segments: Bioproducts and Health Care. The Bioproducts segment develops and delivers products and services to the
industrial, consumer and agri-processing markets to a global customer base.
All of the Companys current product revenues are derived from this segment. The Health Care segment is focused on expanding the Companys current
technology and product platforms into the health care market. This segment is
primarily engaged in the performance of research and development, the securing
of intellectual property and the establishment of strategic investments and
collaborations. The following table provides information by business segment: For the three months ended March 31, 2004Corporate
    
    ConsolidatedBioproducts
    
    Health Care
    
    Segment Subtotal
    
    and Other
    
    TotalsProduct revenue
    
    $
    91,539
    
    
    $
    
    
    
    $
    91,539
    
    
    $
    
    
    
    $
    91,539Fees and royalty revenues
    
    
    2,599
    
    
    
    225
    
    
    
    2,824
    
    
    
    
    
    
    
    2,824Total revenues
    
    
    94,138
    
    
    
    225
    
    
    
    94,363
    
    
    
    
    
    
    
    94,363Research and development
    
    
    10,976
    
    
    
    5,904
    
    
    
    16,880
    
    
    
    
    
    
    
    16,880Operating income/(loss)
    
    
    23,942
    
    
    
    (6,797
    )
    
    
    17,145
    
    
    
    (219
    )
    
    
    16,926
 For the three months ended March 31, 2003Corporate
    
    ConsolidatedBioproducts
    
    Health Care
    
    Segment Subtotal
    
    and Other
    
    TotalsProduct revenue
    
    $
    90,038
    
    
    $
    
    
    
    $
    90,038
    
    
    $
    
    
    
    $
    90,038Fees and royalty revenues
    
    
    5,548
    
    
    
    75
    
    
    
    5,623
    
    
    
    
    
    
    
    5,623Total revenues
    
    
    95,586
    
    
    
    75
    
    
    
    95,661
    
    
    
    
    
    
    
    95,661Research and development
    
    
    10,320
    
    
    
    6,140
    
    
    
    16,460
    
    
    
    
    
    
    
    16,460Operating income/(loss)
    
    
    19,058
    
    
    
    (7,906
    )
    
    
    11,152
    
    
    
    (389
    )
    
    
    10,763
 11




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The following table provides a reconciliation of segment information to
total consolidated information: Three months endedMarch 31,2004
    
    2003Net income:Operating income/(loss) for
reportable segment
    
    $
    17,145
    
    
    $
    11,152Other (income)/expense
    
    
    219
    
    
    
    389Interest expense
    
    
    1,536
    
    
    
    2,020Interest income
    
    
    (871
    )
    
    
    (845
    )Provision for income
taxes
    
    
    3,252
    
    
    
    3,068Consolidated net income
    
    $
    13,009
    
    
    $
    6,520
 12  Technology Transfer During
March 2004, the Company sold its therapeutic vaccine program to
Innogenetics N.V. Upon transfer of certain intellectual property,
contractual relationships and technologies to Innogenetics, the
Company expects to recognize license fees in the second or third
quarter of 2004 totaling $10,000. The Company expects to receive
further payments as development milestones are achieved. Once products are
commercialized, the Company would also receive royalty payments on
further product sales. 12




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our financial condition and results of
operations should be read in conjunction with the consolidated financial
statements and the notes to those statements included in our 2003 Annual Report
onForm 10-Kand the condensed consolidated unaudited financial statements and
related notes included elsewhere in this Report. Executive Summary Leveraging over twenty years of experience, we use our molecular
technologies to develop products and deliver services for varied markets, some
on a global basis. Since our research and commercial expertise and
competencies are at the molecular level we can produce products and deliver
services to many different types of industries. Our current revenues result
primarily from the sale of enzyme products as ingredients or processing aids to
the cleaning, textiles, sweeteners, fuel ethanol and food, feed and specialties
markets, and from research funding, fees and royalties. In the three months
ended March 31, 2004, we expended $11.0 million on our Bioproducts research and
development programs. In addition to developing products for our current
Bioproduct markets, we are now involved in Bioproduct research projects and
programs that are directed toward providing new products and services in the
emerging fields of biomaterials, biochemicals and nanobiotechnology.
Furthermore, we expended $5.9 million in the first quarter of 2004 on our
Health Care programs. We believe that this diversification of our research and
development expenditures will increase the probability of achieving success in
our commercial portfolio and result in increased value for our stockholders. Overall, for the three months ended March 31, 2004, net income available
to common stockholders was $11.2 million, or $0.18 per diluted share, compared
to $4.7 million or $0.08 per diluted share during the same period in 2003.
Product revenues increased by 2% to $91.5 million, compared to $90.0 million in
the first quarter of 2003. Total revenues for the three months ended March 31,
2004 were $94.4 million, compared to $95.7 million for the same period in 2003.
Fees and royalty revenues were $2.8 million in the first quarter as compared
to $5.6 million in the prior year. For the three months ended March 31, 2004,
we generated $16.9 million in operating income and $6.3 million in cash flow
from operations. We also invested $3.7 million in purchases of property, plant
and equipment and made the third of five annual installment payments of $28.0 million on our senior debt during the quarter. Our Bioproducts segment continues to generate all of our product revenues.
In the three months ended March 31, 2004, product revenue growth was 2%,
reflecting the benefits of foreign currency translation and the impact of
on-going profitability improvement initiatives, including the selective pruning
of specific product lines. First quarter revenue growth was also impacted by
the timing of certain customer orders and our integration and rationalization
of our year-end 2002 acquisition of the brewing and enzyme business of Rhodia
Food UK Limited, including the disposition of non-enzyme product lines in
mid-2003. We manufacture our products at our eight Bioproducts manufacturing
facilities located in the United States, Finland, Belgium, China and Argentina.
We conduct our sales and marketing activities through our direct sales
organizations in the United States, the Netherlands, Singapore, Japan, China,
United Kingdom and Argentina and through other distribution channels in
selected markets and geographies. For the three months ended March 31, 2004,
we derived approximately 55% of our revenues from our foreign operations. During the first quarter, we also made significant progress on new
applications within the Bioproducts segment. In the area of biodefense, we
obtained an exclusive license from the U.S. Army Edgewood Chemical and
Biological Center for the manufacture and sale of enzymes to decontaminate
certain organophosphate-based nerve agents, such as sarin. While neutralizing
chemical agents, these enzymes are non-toxic, non-corrosive and environmentally
benign. We believe these products may generate initial revenues later this
year. In addition, working closely with the Health Protection Agency in the
United Kingdom, we have made significant progress in the development of an
enzyme-based method that effectively eliminates prion infectivity. Prions are
widely seen as the causative agent of Bovine Spongiform Encephalopathy
(commonly known as mad cow disease), and its human variant, Cruetzfelt-Jakob
Disease. In our personal care initiative, testing and evaluation of our
ingredients continued among leading consumer products companies, focusing on
oral, skin and hair care applications. Research also continued on other
Bioproducts projects, including Silicon
BiotechnologyTM, our
collaboration with the Dow Corning Corporation focusing on biosensors and other
novel products, and the conversion of biomass to fuel ethanol. In our Health Care segment, we launched our first clinical trial of a
therapeutic product candidate during the three months ended March 31, 2004.
Also, as more completely discussed under the heading Technology
Transfer in
this Item 2, we sold our therapeutic vaccine program to Innogenetics N.V. in
March. We believe this sale is consistent with our plan to focus and further
strengthen our internal research and development efforts in protein-based
therapeutics. While this transaction has the potential to generate additional
milestone and royalty revenues in the future, we expect to recognize license
fees in the second or third quarter of 2004 totaling $10.0 million once we have
transferred certain intellectual property, contractual relationships and
technologies. With the sale of our therapeutic vaccine program, our Health Care segment
is continuing to focus and expand its investment in targeted biotherapeutics.
During the three months ended March 31, 2004, we advanced our first product
candidate for treating cancer into Investigational New Drug Application
(IND)-enabling development. The lead product candidate is based on the
Antibody Directed Enzyme Prodrug Therapy (ADEPT) platform and will target
colorectal carcinoma. The preliminary timeline anticipates filing an IND in
2005 followed by the launch of clinical trials. We also continued to make
progress during the quarter on the validation phase of our facility for the
clinical-scale manufacture of human therapeutic proteins in
Rochester, New York. Our Health Care segment maintains its strategy of creating a biotherapeutics pipeline
to address unmet medical needs and continues to evaluate appropriate
in-licensing opportunities in development-stage molecules that would supplement
its internal pipeline. We are pleased with our progress during the first quarter of 2004. In
both of our segments, we took actions during the first quarter that increased
our focus on higher growth and more profitable products. We believe some of
those actions reduced our rate of revenue growth in the short-term but should
have a positive impact on our revenue growth and profitability in the
long-term. As more completely discussed under the heading Warehouse Inventory
Loss in this Item 2, we are also pleased to have settled our insurance claim
from last years third-party warehouse accident, which resulted in a net gain
of $8.3 million for the quarter.


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Results of Operations Comparison of the Three Months Ended March 31, 2004 and 2003 Revenues.Total revenues decreased $1.3 million, or 1%, to $94.4 million
for the three-month period ended March 31, 2004 from the three-month period
ended March 31, 2003, primarily due to a decrease in fees and royalty revenues
partially offset by an increase in product revenue. Product Revenues.Product revenues increased $1.5 million, or 2%, to $91.5
million for the three months ended March 31, 2004 from the three months ended
March 31, 2003. For the three months ended March 31, 2004, product revenues
decreased 2% due to unit volume/mix and 2% due to a decline in
average prices, while the impact of foreign currency
increased product revenues by 6%. The volume/mix decrease was primarily driven by decreased sales
to our food, feed and specialties and sweeteners markets. Regionally, North American product revenues decreased $1.0 million, or 3%,
to $36.6 million for the three months ended March 31, 2004 from the three
months ended March 31, 2003, driven primarily by decreased sales to our
cleaning, textile, and sweeteners markets, partially offset by increased sales
to our fuel ethanol and food, feed and specialties markets. Product revenues
in Europe, Africa and the Middle East increased $4.1 million, or 11%, to $40.0
million for the three months ended March 31, 2004 from the three months ended
March 31, 2003, driven primarily by increased sales to our cleaning, textile,
and sweetener markets, partially offset by decreased sales to fuel ethanol and
food, feed and specialties markets. Our product revenues in the Asia Pacific
region decreased $1.6 million, or 12%, to $11.6 million for three months ended
March 31, 2004 from the three months ended March 31, 2003 due to decreased
sales to our cleaning, textile, sweetener and food, feed and specialties
markets, partially offset by sales to our fuel ethanol markets. Our product
revenues in Latin America remained constant at $3.3 million for the three
months ended March 31, 2004 and the three months ended March 31, 2003. Fees and Royalty Revenues.Fees and royalty revenues decreased $2.8
million, or 50%, to $2.8 million, for the three months ended March 31, 2004
from the three months ended March 31, 2003. Funded research revenues decreased $3.0 million, or 59%, to $2.1 million
for the three months ended March 31, 2004 from the three months ended March 31,
2003. Revenues generated by research funding result from collaborative
agreements with various parties, including the U.S. Government, whereby we
perform research activities and receive revenues that partially reimburse us
for expenses incurred. Under such agreements, we retain a proprietary interest
in the products and technology developed. Our funded research revenue as it relates to U.S. Government
collaborations, primarily our efforts to develop an enzymatic process
to convert biomass into bioethanol for the National Renewable Energy
Laboratory, decreased $0.1 million, or 9%, to $1.0 million for the
three months ended March 31, 2004 from the three months ended
March 31, 2003. Funded research revenues provided by customers decreased $2.9
million, or 73%, to $1.1 million for the three months ended March 31, 2004 from
the three months ended March 31, 2003, primarily driven by the completion of
the initial stages of our strategic alliance with the Dow Corning Corporation. Royalty revenues are based on the sales of customers products produced
using our technology. Royalties increased $0.2 million, or 40%, to $0.7
million for the three months ended March 31, 2004 from the three months ended
March 31, 2003. License fees remained constant at less then $0.1 million for the three
months ended March 31, 2004 and the three months ended March 31, 2003. These
fees are related to the sale of rights to third parties for the use of our
technology and patents to manufacture products. Operating Expenses Cost of Products Sold.Cost of products sold decreased $0.3 million, or
1%, to $50.5 million for the three months ended March 31, 2004 from the three
months ended March 31, 2003. The decrease in sales volume/mix reduced costs by
$0.4 million. Also unit production costs were $2.9 million lower. These
benefits were partially offset by the impact of the weaker U.S. Dollar against
foreign currencies, primarily the Euro, of $3.0 million. Gross Profit and Margins from Products Sold.Gross profit from products
sold increased $1.9 million, or 5%, to $41.1 million for the three months ended
March 31, 2004 from the three months ended March 31, 2003. This overall
increase was caused by a $2.7 14




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million impact due to the weaker U.S. Dollar against foreign currencies
primarily the Euro and lower unit production costs of $2.9 million. These
increases were partially offset by a 2% decrease in volume/mix processed
through our plants and an average price decline of 2%. As a result of these
factors, gross margin on product revenue increased to 44.9% in the three months
ended March 31, 2004 from 43.5% in the three months ended March 31, 2003. Research and Development.Research and development expenses primarily
consist of the personnel-related, consulting, and facilities costs incurred in
connection with our research activities conducted in Palo Alto, California and
Leiden, the Netherlands. These expenses increased $0.4 million, or 2%, to
$16.9 million for the three months ended March 31, 2004 from the three months
ended March 31, 2003, due primarily to increases in personnel-related costs,
including salaries, benefits and travel expenses of $0.4 million, facilities of
$0.2 million and supplies of $0.1 million, partially offset by decreases in
outside services of $0.3 million and incentive compensation of $0.1 million.
As a part of total research and development expenses, estimated expenses
related to research collaborations partially funded by customers decreased $1.1
million, or 35%, to $2.0 million for the three months ended March 31, 2004 from
the three months ended March 31, 2003. Sales, Marketing and Business Development.Sales, marketing and business
development expenses primarily consist of the personnel-related and marketing
costs incurred by our global sales force. These expenses increased $0.6
million, or 8%, to $8.3 million for the three months ended March 31, 2004 from
the three months ended March 31, 2003, due primarily to increased
personnel-related costs, including salaries, benefits, and travel expenses of
$0.6 million and an increase in the provision for doubtful accounts at our
Chinese affiliate of $0.2 million, partially offset by a decrease in outside
services of $0.3 million. General and Administrative.General and administrative expenses include
the costs of our corporate executive, finance, information technology, legal,
human resources, and communications functions. In total, these expenses
increased $0.7 million, or 9%, to $8.5 million for the three months ended
March 31, 2004 from the three months ended March 31, 2003, due primarily to
increases in outside services of $0.8 million, partially offset by decreased
personnel-related costs, including salaries, benefits and travel expenses of
$0.1 million. Amortization of Intangible Assets.We amortize our definite-lived
intangible assets, consisting primarily of patents, licenses and customer
lists, on a straight-line basis over their estimated useful lives.
Amortization expense decreased $0.2 million, or 14%, to $1.2 million for the
three months ended March 31, 2004 from the three months ended March 31, 2003. Other Expense and Income.Other income for the three months ended March
31, 2004 was $7.9 million as compared with other expense of $0.7 million for
the three months ended March 31, 2003. The increase in other income for the
three months ended March 31, 2004 was primarily driven by the $8.3 million net
gain resulting from the final settlement of our insurance claim related to the
warehouse accident in Rotterdam, the Netherlands that occurred in the second
quarter of 2003. Non Operating Expense and Income Interest Income. Interest income was $0.9 million for the three months
ended March 31, 2004, which was an increase of less than $0.1 million from
the three months ended March 31, 2003. Income Taxes. The effective income tax rate was 20% for the three months
ended March 31, 2004, compared to 32% for the three months ended March 31,
2003, which reflects our assessment of the annual effective income tax rate.
Factors that affect our estimated annual effective income tax rate include
increased research and development expenditures in the United States, the
statutory income tax rates in foreign jurisdictions and the relative amount of
income in each jurisdiction, other operating expense increases and other items
which are not deductible for tax purposes, and research and experimentation tax
credits. In addition, the estimated annual effective rate for the three months
ended March 31, 2003 included the effect of estimated valuation allowances,
since we did not anticipate having the ability to utilize certain tax credits. Financial Results by Segment Our managerial financial reporting provides information that aligns with
the two-segment structure of Bioproducts and Health Care. Accordingly, we have
provided financial data in this financial segment-reporting for the three
months ended March 31, 2004 and 2003. 15




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The Bioproducts segment develops and delivers products and services for
the industrial, consumer and agri-processing markets to a global customer base.
All of our current product revenues are derived from this segment. For the
three months ended March 31, 2004, the Bioproducts segment achieved operating
income of $23.9 million as compared to operating income of $19.1 million for
the three months ended March 31, 2003. The Health Care segment is primarily engaged in the performance of
research and development, securing intellectual property and the establishment
of strategic investments and collaborations in support of our product
objectives in the health care market. For the three months ended March 31,
2004, the Health Care segment experienced an operating loss of $6.8 million as
compared to an operating loss of $7.9 million for the three months ended March
31, 2003. Warehouse Inventory Loss We sustained damage to our finished bioproducts
inventory in the second quarter of 2003 as a result of an accident in a third
party warehouse in Rotterdam, the Netherlands. At the end of the first quarter
of 2004, we reached final settlement of our
accident-related claim with our insurer totaling approximately
$21.0 million. This settlement resulted in a net
gain of $8.3 million for the quarter. Of the total settlement,
we have
received cash payments of approximately $9.4 million from our insurer through
March 31, 2004. Technology Transfer During
March 2004, we sold our therapeutic vaccine program to
Innogenetics N.V., a biotechnology company with a long-term
commitment to therapeutic vaccine strategies. Upon transfer of
certain intellectual property, contractual relationships and
technologies to Innogenetics, we expect to recognize license fees in
the second or third quarter of 2004 totaling $10.0 million. We expect
to receive further payments
as development milestones are achieved. Once products are commercialized, we
will also receive royalty payments on future product sales. Liquidity and Capital Resources Our funding needs consist primarily of capital expenditures, research and
development activities, sales and marketing expenses, and general corporate
purposes. We have financed our operations primarily through cash from the sale
of products, the sale of stock, research and development funding from partners,
government grants, and short-term and long-term borrowings. We believe that our current cash and cash equivalent balances plus funds
to be provided from our current year operating activities, together with those
available under our lines of credit, will satisfy our funding needs over the
next twelve months. Factors that could negatively impact our cash position
include, but are not limited to, future levels of product revenues, fees and
royalty revenues, expense levels, capital expenditures, acquisitions, and
foreign currency exchange rate fluctuations. As of March 31, 2004, cash and cash equivalents totaled $139.5 million.
The funds were invested in short-term instruments, including A-1/P-1 and
A-2/P-2 rated commercial paper, AAA/Aaa and AA/Aa2 rated medium term notes, as
rated by Standard & Poor and Moodys, respectively. Additionally the funds were
invested in institutional money market funds, auction rate preferred securities
and bank deposits. Cash provided by operations was $6.3 million for the three months ended
March 31, 2004 and cash used by operations was $0.2 million for the three
months ended March 31, 2003. The increase of $6.5 million for the year ended
March 31, 2004 from the three months ended March 31, 2003, was driven by
increases in operating earnings, net of non-cash items such as depreciation and
amortization, partially offset by changes in operating assets and liabilities. Cash used in investing activities was $4.2 million and $4.6 million for
the three months ended March 31, 2004 and 2003, respectively. This decrease of
$0.4 million was driven primarily by a $0.8 million decrease in capital
spending for the three months ended March 31, 2004. This was partially offset
by $0.6 million of additional payments related to the 2002 year-end acquisition
of the brewing and enzyme business of Rhodia Food UK Limited. Capital
expenditures for the first quarter were $3.7 million in 2004 16




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compared with $4.5 million in 2003. A significant portion of this
spending included process improvement projects at our manufacturing and
research and development facilities and information technology
enhancements. During the three months ended March 31, 2003,
construction continued on our facility for the clinical-scale
manufacture of human therapeutic proteins in Rochester, New York.
Construction of this facility was completed during the
three months ended September 30, 2003. Cash
used in financing activities was $27.3 million and
$27.5 million for the three
months ended March 31, 2004 and 2003, respectively, which primarily consisted of our $28.0
million annual installment payments made on our senior debt in each
period. No dividends were
paid to common stockholders during the three months ended March 31, 2004.
While we are permitted to pay dividends, we currently intend to retain future
earnings to finance the expansion of our business. Any future determination to
pay cash dividends to our common stockholders will be at the discretion of our
board of directors and will depend upon our financial condition, results of
operations, capital requirements, general business conditions and other factors
that the board of directors may deem relevant, including covenants in our debt
instruments that may limit our ability to declare and pay cash dividends on our
capital stock. Covenants in our senior note agreement restrict the payment of
dividends or other distributions in cash or other property to the extent the
payment puts us in default of these covenants. Such covenants include, but are
not limited to, maintaining a debt to total capitalization of no greater than
55% and a maximum ratio of debt to earnings before interest, taxes,
depreciation and amortization (EBITDA) of 3.5:1. At March 31, 2004, we had a $40.0 million revolving credit facility with a
syndicate of banks, which is available for general corporate purposes. The
credit facility, which consists of a credit agreement, makes available to the
Company $40.0 million of committed borrowings and expires on December 23, 2006.
The credit facility fees were 0.30% on the amount of unborrowed principal
under the agreement for the three months ended March 31, 2004. As of March 31,
2004, there were no borrowings under the facility. Our long-term debt consists primarily of the 6.82% senior notes issued in
1996 to certain institutional investors. The remaining principal amount of
these notes is $56.0 million. Annual installment payments of $28.0 million
commenced on March 30, 2002. We are currently in compliance with the financial
covenants included in the senior note agreement. New Accounting Pronouncements In December 2003, the FASB issued a revision of SFAS No. 132, Employers
Disclosures about Pensions and Other Postretirement Benefits. The revised
Statement provides required disclosures for pensions and other postretirement
benefit plans and is designed to improve disclosure transparency in financial
statements. The revised Statement replaces existing year-end and interim
disclosure requirements. This Statement was in effect for our fiscal year
ending December 31, 2003 and for quarters beginning thereafter for domestic
plans, and will be effective for fiscal years ending after June 15, 2004 for
our foreign plans. In January 2004, the FASB issued FASB Staff Position No. FAS 106-1,
Accounting and Disclosure Requirements Related to the Medicare Prescription
Drug, Improvement and Modernization Act of 2003. This Position permits
employers that sponsor postretirement benefit plans that provide prescription
drug benefits to retirees to make a one-time election to defer accounting for
any effects of the Medicare Prescription Drug, Improvement and Modernization
Act of 2003 (Act). Specific authoritative guidance on the accounting for the
federal subsidy is pending and that guidance, when issued, could require the
sponsor of such a plan to change previously reported information. Our
financial statements do not reflect any implications of the Act due to the
level of uncertainty about the forthcoming guidance. Market Risk Foreign currency risk and interest rate risk are the primary sources of
our market risk. To date foreign operations, mainly denominated in Euros,
accounted for approximately 55% of our revenues for the three months ended
March 31, 2004. We believe that we mitigate this risk by locating our
manufacturing facilities so that the costs are denominated in the same currency
as our product revenues. We may manage the foreign currency exposures that
remain through the use of foreign currency forward contracts, currency options
and off-setting currency positions in assets and liabilities where deemed
appropriate. We do not use these instruments for speculative purposes. As of March 31, 2004, cash and cash equivalents totaled $139.5 million.
Of this amount, $79.6 million was denominated in Euros. The remainder, or $59.9
million, was primarily denominated in U.S. Dollars. Short-term debt was mainly
comprised of our fourth installment of $28.0 million due March 30, 2005 under
our 6.82% senior notes discussed under the heading Liquidity and Capital
Resources in this Report. To the extent U.S. Dollar and Euro interest rates
fluctuate either up or down, the return on the cash 17




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investments will also fluctuate. To the extent such Euro cash investments
remain outstanding, we will be subject to the risks of future foreign exchange
fluctuations and the impact on the translation of these cash investments into
U.S. Dollars. Interest Rates Our interest income is sensitive to changes in the general level of
short-term interest rates primarily in the United States and Europe. In this
regard, changes in the U.S. Dollar and Euro currency rates affect the interest
earned on our cash equivalents, short-term investments, and long-term
investments. Our interest expense is generated primarily from fixed rate debt.
The $56.0 million 6.82% senior notes outstanding at March 31, 2004 mature
evenly in installments of $28.0 million per year. The two remaining
installments are due March 30, 2005 and 2006. Foreign Currency Exposure We conduct business throughout the world. During the three months ended
March 31, 2004, we derived approximately 55% of our revenues and
approximately 45% of our operating income from foreign
operations. Economic
conditions in countries where we conduct business and changing foreign currency
exchange rates affect our financial position and results of operations. We are
exposed to changes in foreign exchange rates in Europe, Latin America, and
Asia. The Euro and Argentine Peso present our most significant foreign
currency exposure risk. Changes in foreign currency exchange rates, especially
the strengthening of the U.S. Dollar, may have an adverse effect on our
financial position and results of operations as they are expressed in U.S.
Dollars. Our manufacturing and administrative operations for Latin America are
located in Argentina. A significant part of our Latin American revenues are
denominated in U.S. Dollars. Net foreign exchange loss from U.S. Dollar/Euro
and U.S. Dollar/Argentine Peso transactions were $0.2 million for the
three-month period ended March 31, 2004. Management monitors foreign currency exposures and may in the ordinary
course of business enter into foreign currency forward contracts or options
contracts related to specific foreign currency transactions or anticipated cash
flows. These contracts generally cover periods of nine months or less and are
not material. For the three months ended March 31, 2004,
foreign currency contracts had an approximately neutral impact on our
statement of operations. We do not hedge the translation of financial statements of
consolidated subsidiaries that maintain their local books and records in
foreign currencies. 18




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Risk Factors Biotechnology and especially the development of products for the health
care market are areas of intense competition and high risk. While we believe
that our business is unique in its history and areas of focus, the risk factors
described below or other risks not known to us now or that we currently believe
to be immaterial may have a material and adverse effect on our business,
financial condition, results of operations, or the price of our common stock. If we fail to develop products for the health care and bioproducts markets, we
may not achieve a return on our research and development expenditures or
realize product revenues from these markets. A key element of our business strategy is to utilize our technologies for
the development and delivery of new products to the health care market and new
sectors of the bioproducts market. We intend to continue to invest heavily in
research and development to develop products for these markets. The successful
development of these products, especially those in the health care market, is
highly uncertain and is dependent on numerous factors, many of which are beyond
our control, and may include the following:  
    
    The product may be ineffective or have undesirable side effects in preliminary and commercial testing or, specifically in
the health care area, in preclinical and clinical trials;
    
    The product may fail to receive necessary governmental and regulatory approvals, or such regulatory approvals may be
delayed significantly;
    
    The product may not be economically viable because of manufacturing costs or other factors;
    
    The product may not gain acceptance in the marketplace; or
    
    The proprietary rights of others or competing products or technologies for the same application may preclude us from
commercializing the product. Due to these factors we may never achieve a return on our research and
development expenditures or realize product revenues from the health care and
new bioproducts markets that we are targeting. If we fail to enter into strategic alliances with partners in our target
markets or fail to independently raise additional capital, we will not have the
resources necessary to capitalize on all of the market opportunities available
to us. We do not currently possess the resources necessary to independently
develop and commercialize products for all of the market opportunities that may
result from our technologies. We intend to form strategic alliances with
industry leaders in our target markets to gain access to funding for research
and development, expertise in areas we lack and distribution channels. We may
fail to enter into the necessary strategic alliances or fail to commercialize
the products anticipated from the alliances. Our alliances could be harmed if:  We fail to meet our agreed upon research and development objectives; We disagree with our strategic partners over material terms of the alliances, such as intellectual property or
manufacturing rights; or  Our strategic partners become competitors or enter into agreements with our competitors. New strategic alliances that we enter into, if any, may conflict with the
business objectives of our current strategic partners and negatively impact
existing relationships. In addition, to capitalize on the market opportunities
we have identified, we may need to seek additional capital, either through
private or public offerings of debt or equity securities. Due to market and
other conditions beyond our control, we may not be able to raise additional
capital on acceptable terms or conditions, if at all. 19




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If the demand for protein degrading enzymes decreases or if major customers
reduce or terminate business with us, our revenues could significantly decline. Our largest selling family of products, protein degrading enzymes, or
proteases, accounted for approximately 48% of our 2003 product revenues. If the
demand for proteases decreases or alternative proteases render our products
noncompetitive, our revenues could significantly decline. In addition, our five largest customers collectively accounted for
approximately 53% of our 2003 product revenues, with our largest customer, The
Procter & Gamble Company, accounting for more than 35% of such revenues. Our
five largest customers in 2003 were Broin Group; Cargill, Incorporated; Danisco
Animal Nutrition  the feed ingredients business unit of Danisco A/S; The
Procter & Gamble Company; and Reckitt Benckiser, plc. Any one of these
customers may reduce their level of business with us. Should any of our
largest customers decide to reduce or terminate business with us, our revenues
and profitability could decline significantly. We have arrangements of various durations with our major customers and are
routinely involved in discussions regarding the status of these relationships.
These discussions may lead to extensions or new commercial arrangements, or may
be unsuccessful. Our customer relationships involve uncertainty by virtue of
economic conditions, customer needs, competitive pressures, our production
capabilities and other factors. Consequently, we expect that our customer base
will continue to change over time as will the nature of our relationships with
individual customers, including major customers. We intend to acquire businesses, technologies and products; however, we may
fail to realize the anticipated benefits of such acquisitions and we may incur
costs that could significantly negatively impact our profitability. In the future, we may acquire other businesses, technologies and products
that we believe are a strategic fit with our business. If we undertake any
transaction of this sort, we may not be able to successfully integrate any
businesses, products, technologies or personnel that we might acquire without a
significant expenditure of operating, financial and management resources, if at
all. Further, we may fail to realize the anticipated benefits of any
acquisition. Future acquisitions could dilute our stockholders interest in us
and could cause us to incur substantial debt, expose us to contingent
liabilities and could negatively impact our profitability. If we are unable to secure or maintain adequate intellectual property
protection or become involved in an intellectual property dispute, it could
significantly harm our financial results and ability to compete. The patent positions of biotechnology companies, including our patent
positions, can be highly uncertain and involve complex legal and factual
questions, and, therefore, enforceability is uncertain. We will be able to
protect our proprietary rights from unauthorized use by third parties only to
the extent that we protect our technologies with valid and enforceable patents
or as trade secrets. We rely in part on trade secret protection for our
confidential and proprietary information by entering into confidentiality
agreements and non-disclosure policies with our employees and consultants.
Nonetheless, confidential and proprietary information may be disclosed, and
others may independently develop substantially equivalent information and
techniques or otherwise gain access to our trade secrets. We file patent applications in the United States and in foreign countries
as part of our strategy to protect our proprietary products and technologies.
The loss of significant patents or the failure of patents to issue from pending
patent applications that we consider significant could impair our operations.
In addition, third parties could successfully challenge, invalidate or
circumvent our issued patents or patents licensed to us so that our patent
rights would not create an effective competitive barrier. Further, we may not
obtain the patents or licenses to technologies that we will need to develop
products for our target markets. The laws of some foreign countries may also
not protect our intellectual property rights to the same extent as United
States law. Extensive litigation regarding patents and other intellectual property
rights is common in the biotechnology industry. In the ordinary course of
business, we periodically receive notices of potential infringement of patents
held by others and patent applications that may mature to patents held by
others. The impact of such claims of potential infringement, as may from time
to time become known to us, are difficult to assess. In the event of an
intellectual property dispute, we may become involved in litigation.
Intellectual property litigation can be expensive and may divert managements
time and resources away from our operations. The outcome of any such
litigation is inherently uncertain. Even if we are successful, the litigation
can be costly in terms of dollars spent and diversion of management time. 20




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If a third party successfully claims an intellectual property right to
technology we use, it may force us to discontinue an important product or
product line, alter our products and processes, pay license fees, pay damages
for past infringement or cease certain activities. Under these circumstances,
we may attempt to obtain a license to this intellectual property; however, we
may not be able to do so on commercially reasonable terms, or at all. In
addition, regardless of the validity of such a claim, its mere existence may
affect the willingness of one or more customers to use or continue to use our
products and, thereby, materially impair our business. Those companies with which we have entered or may enter into strategic
alliances encounter similar risks and uncertainties with respect to their
intellectual property. To the extent that any such alliance companies suffer a
loss or impairment of their respective technologies, we may suffer a
corresponding loss or impairment that may materially and adversely affect our
investments. Also, our patent portfolio includes patents that are nearing the end of
their period of protection. While we do not expect to experience a material
adverse effect related to patent expirations in the near term, the expiration
of patents may submit us to new competition and price pressures that may lead
to a significant loss of product revenue. Foreign currency fluctuations and economic and political conditions in foreign
countries could cause our revenues and profits to decline. In 2003, we derived approximately 55% of our product revenues from our
foreign operations. Our foreign operations generate sales and incur expenses
in local currency. As a result, we are exposed to market risk related to
unpredictable interest rates and foreign currency exchange rate fluctuations.
We recognize foreign currency gains or losses arising from our operations in
the period incurred. As a result, currency fluctuations between the U.S.
Dollar and the currencies in which we do business could cause our revenues and
profits to decline. Product revenues denominated in Euros accounted for approximately 37% of
our total product revenues in 2003, and the fluctuations in the currency
exchange rate against the U.S. Dollar can have a significant impact on our
reported product revenues. We expect to continue to operate in foreign countries and that our
international sales will continue to account for a significant percentage of
our revenues. As such, we are subject to certain risks arising from our
international business operations that could be costly in terms of dollars
spent, the diversion of managements time, and revenues and profits, including:  
    
    Difficulties and costs associated with staffing and managing foreign operations;
    
    Unexpected changes in regulatory requirements;
    
    Difficulties of compliance with a wide variety of foreign laws and regulations;
    
    Changes in our international distribution network and direct sales forces;
    
    Political trade restrictions and exchange controls;
    
    Political, social, or economic unrest including armed conflict and acts of terrorism;
    
    Labor disputes including work stoppages, strikes and embargoes;
    
    Inadequate and unreliable services and infrastructure;
    
    Import or export licensing or permit requirements; and
    
    Greater risk on credit terms and long accounts receivable collection cycles in some foreign countries. 21




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If the ownership of our common stock continues to be highly concentrated, it
may prevent other stockholders from influencing significant corporate decisions
and may result in conflicts of interest that could cause our stock price to
decline. After our initial public offering and continuing to the present, Eastman
Chemical Company and Danisco A/S and their affiliates, which we refer to as our
majority stockholders, each own in excess of 40% of our outstanding common
stock. Moreover, pursuant to a Stockholder Agreement, as amended, among
Eastman, Danisco and us, each of our majority stockholders also has the right
to nominate three of our ten directors. The majority stockholders will
therefore have the ability, in the event they act together, to control
fundamental corporate transactions requiring stockholder approval, including
the election of our directors, the approval of merger transactions involving
us, and the sale of all or substantially all of our assets or other business
combination transactions. The concentration of ownership of our common stock
may have the effect of either delaying or preventing a change to our control
favored by our other stockholders or accelerating or approving a change to our
control opposed by our other stockholders. In addition, the majority
stockholders control over our management could create conflicts of interest
between the majority stockholders and us with respect to the allocation of
corporate opportunities and between the majority stockholders and other
stockholders. If stockholders sell large numbers of shares of our common stock, our stock
price could decline. The market price of our common stock could decline as a result of sales of
our stock into the public market or the perception that these sales could
occur. Our two majority stockholders, for example, hold more than 80% of our
common stock, and all of these shares are subject to registration rights. In
addition, we have a significant number of stock options outstanding with our
officers, directors and employees pursuant to our 2002 Omnibus Incentive Plan,
approved by our stockholders in May 2002, and its predecessor plan. Our stock price has been, and may continue to be, particularly volatile. The stock market from time to time, has experienced significant price and
volume fluctuations that are unrelated to the operating performance of
companies. The market prices for securities of biotechnology companies,
including ours, have been highly volatile in the period since our initial
public offering in July 2000 and may continue to be highly volatile in the
future. Our stock may be affected by this type of market volatility, as well as
by our own performance. The following factors, among other risk factors, may
have a significant effect on the market price of our common stock:  
    
    Developments in our relationships with current or future strategic partners;
    
    Conditions or trends in the biotechnology industry;
    
    Announcements of technological innovations or new products by us or our competitors;
    
    Announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital
commitments;
    
    Developments in patent or other intellectual proprietary rights or announcements relating to these matters;
    
    Investor concern regarding the public acceptance of the safety of biotechnology products or announcements relating to these
matters;
    
    Litigation or governmental proceedings or announcements relating to these matters;
    
    Economic and other external factors or other disaster or crisis;
    
    Future royalties from product sales, if any, by our licensees;
    
    Sales of our common stock or other securities in the open market; and
    
    Period-to-period fluctuations in our operating results. 22




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We expect that our quarterly results of operations will fluctuate, and this
fluctuation could cause our stock price to decline, causing investor losses. A large portion of our expenses, including expenses for facilities,
equipment and personnel, are relatively fixed. Accordingly, if product revenue
declines or does not grow as we anticipate or non-product revenue declines due
to the expiration or termination of strategic alliance agreements or the
failure to obtain new agreements or grants, we may not be able to
correspondingly reduce our operating expenses in any particular quarter. Our
quarterly revenue and operating results have fluctuated in the past and are
likely to do so in the future. If our operating results in some quarters fail
to meet the expectations of stock market analysts and investors, our stock
price would likely decline. Some of the factors that could cause our revenue
and operating results to fluctuate include:  
    
    The ability and willingness of strategic partners to commercialize products derived from our technology or containing our
products on expected timelines;
    
    Our ability to successfully commercialize products developed independently and the rate of adoption of such products;
    
    Fluctuations in consumer demand for products containing our technologies or products, such as back to school sales of blue
jeans and other denim products, resulting in an increase in the use of textile processing enzymes, and fluctuations in
laundry detergent use due to promotional campaigns run by consumer products companies; and
    
    Fluctuations in geographic conditions including currency and other economic conditions such as economic crises in Latin
America or Asia and increased energy and related transportation costs. We also have incurred significant infrequently occurring charges within
given quarters, such as those incurred in conjunction with restructuring
activities and recognized investment income/expense from available-for-sale
marketable securities. Concerns about genetically engineered products could result in our inability to
commercialize products. We produce a significant amount of our products from genetically modified
microorganisms. We cannot predict public attitudes and acceptance of existing
or future products made from genetically modified microorganisms. As a result,
if we are not able to overcome the ethical, legal and social concerns relating
to safety and environmental hazards of genetic engineering, the general public
may not accept our products and this may prevent us from commercializing
products dependent on our technologies or inventions. In addition, public
attitudes may influence laws and regulations governing the ownership or use of
genetic material, which could result in greater government regulation of
genetic research and bioengineered products. If we are subject to a costly product liability damage claim or award, our
profits could decline. We may be held liable if any product we develop, or any product that a
third party makes with the use or incorporation of any of our products, causes
injury or is found otherwise unsuitable during product testing, manufacturing,
marketing or sale. Our current product liability insurance may not cover our
potential liabilities. Inability to obtain sufficient insurance coverage in
the future at an acceptable cost or otherwise to protect against potential
liability claims could prevent or inhibit the commercialization of products
developed by us or our strategic partners. If a third party sues us for any
injury caused by our products, our liability could exceed our insurance
coverage amounts and total assets and our profits could decline. If we are subject to costly environmental liability due to the use of hazardous
materials in our business, our profits could decline. Our research and development processes involve the controlled use of
hazardous materials, including chemical, radioactive and biological materials.
Our operations also generate potentially hazardous waste. We cannot eliminate
entirely the risk of contamination or the discharge of hazardous materials and
any resultant injury from these materials. Federal, state, local and foreign
laws and regulations govern the use, manufacture, storage, handling and
disposal of these materials. Third parties may sue us for any injury or
contamination resulting from our use or the third partys use of these
materials. Any accident could partially or completely shut down our research
and manufacturing facilities and operations. In addition, if we are required
to comply with any additional applicable environmental laws and regulations, we
may incur additional costs, and any such current or future environmental
regulations may impair our research, development or production efforts. 23




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Item 3. Quantitative and Qualitative Disclosures About Market Risk The information presented in Item 2 of Part I of this Report on Form 10-Q
under the heading Market Risk is hereby incorporated by reference. 
 Item 4. Controls and Procedures Disclosure Controls and Internal Controls Disclosure Controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934 (Exchange Act), such as this Report, is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commissions rules and forms. Disclosure
Controls are also designed with the objective of ensuring that such information
is accumulated and communicated to our management, including the Chief
Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure. Internal Controls are procedures which
are designed with the objective of providing reasonable assurance that (1) our
transactions are properly authorized; (2) our assets are safeguarded against
unauthorized or improper use; and (3) our transactions are properly recorded
and reported, all to permit the preparation of our financial statements in
conformity with accounting principles generally accepted in the United States
of America. Accordingly, a control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Because of the inherent limitations
in any control system, misstatements due to error or fraud may occur and not be
detected. Evaluation of Disclosure Controls and Procedures As of the end of the period covered by this Report, we carried out an
evaluation, under the supervision and with the participation of our management,
including Jean-Jacques Bienaimé, our Chairman, Chief Executive Officer and
President, and Raymond J. Land, our Senior Vice President and Chief Financial
Officer, of the effectiveness of our disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)). Based upon that
evaluation, Mr. Bienaimé and Mr. Land concluded that our disclosure controls
and procedures were effective as of the end of the period covered by this
Report. Changes in Internal Controls Over Financial Reporting There has been no change in our internal control over financial reporting
that occurred during the first quarter of 2004 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. 
 PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings Nothing to report 
 Item 2. Change in Securities, Use of Proceeds and Issuer Purchases of Equity Securities The information presented in Item 2 of Part I of this Report on Form 10-Q
under the heading Liquidity and Capital Resources is hereby incorporated by
reference. The Companys Registration Statement on Form S-1 (Registration No.
333-36452) was effective as of July 27, 2000. 
 Item 3. Defaults Upon Senior Securities Nothing to report 24




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Item 4. Submission of Matters to a Vote of Security Holders Nothing to report 
 Item 5. Other Information Nothing to report 
 Item 6. Exhibits and Reports on Form 8-K  a.
    
    Exhibits (2)
    
    Plan of acquisition, reorganization, arrangement, liquidation or succession+2.1           Transfer Agreement between the Company and Innogenetics N.V. dated March 29, 2004(10)
    
    Material Contracts10.1           Letter Agreement, dated February 11, 2003, between Dow Corning Corporation and the Company(31)
    
    Rule 13a-14(a)/15d-14(a) Certifications31.1           Rule 13a-14(a)/15(d)-14(a) Certification of Chief Executive Officer31.2           Rule 13a-14(a)/15(d)-14(a) Certification of Chief Financial Officer(32)
    
    Section 1350 Certifications32.1           Section 1350 Certifications of each of the Chief Executive Officer and the Chief Financial Officer+
    
    Confidential treatment requested as
to certain information which has been omitted from the agreement and
which has been separately filed with the Securities and
Exchange Commission pursuant to an application for such treatment.
  b.
    
    Reports on Form 8-K On February 12, 2004 the Company filed a Current Report on Form 8-K
regarding its press release concerning financial results for the fourth
quarter and full year of 2003. The report included condensed financial
statements and other financial information. 25




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by
the undersigned, thereunto duly authorized. GENENCOR INTERNATIONAL, INC.May 6,
2004
    
    By:
    
    /s/ Raymond J. LandDate
    
    
    
    Raymond J. LandSenior Vice President and Chief Financial Officer(Principal Financial Officer)May 6, 2004
    
    By:
    
    /s/ Darryl L. CanfieldDate
    
    
    
    Darryl L. CanfieldVice President and Corporate Controller(Chief Accounting Officer)
 26




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EXHIBIT INDEX Exhibit Number
    
    Description+2.1
    
    Transfer Agreement between the Company and Innogenetics N.V. dated March 29, 200410.1
    
    Letter Agreement, dated February 11, 2003, between Dow Corning Corporation and the Company31.1
    
    Rule 13a-14(a)/15(d)-14(a) Certification of Chief Executive Officer31.2
    
    Rule 13a-14(a)/15(d)-14(a) Certification of Chief Financial Officer32.1
    
    Section 1350 Certifications of each of the Chief Executive Officer and the Chief Financial
Officer+ Confidential treatment
requested as to certain information which has been omitted from the
agreement and which has been separately filed
with the Securities and Exchange Commission pursuant to an application for such treatment.
 27