**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

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**FORM 10-Q**

 

**ý****      QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

#### **Forthe quarterly period ended March 31, 2003**

** **

**OR**

** **

**o****      TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

#### **Forthe transition period from         to       **

 

**Commission File Number 000-23541**

 

**NANOGEN, INC.**

**(Exact name of Registrant as specifiedin its charter)**

** **
| **Delaware**                                                     |   | **33-0489621**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **10398 Pacific  Center Court, San Diego, CA**                   |   | **92121**                              |
| (Address  of principal executive offices)                        |   | (Zip  code)                            |

 

**(858) 410-4600**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whetherthe 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 (orfor 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 | ý |   | NO | o |
|-----|--------|--------|----|---|

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 
| YES | o |   | NO | ý |
|-----|---|--------|----|--------|

 

**As of May 12, 2003, 22,053,701 shares of the Registrant’sCommon Stock were outstanding.**

 

** **

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**NANOGEN, INC.**

**FORM 10-Q**

**INDEX**

 
| **PART I.**        | **FINANCIAL INFORMATION**                                                                                   |
|--------------------|-------------------------------------------------------------------------------------------------------------|
|               |                                                                                                        |
| Item 1.            | Financial Statements:                                                                                       |
|               |                                                                                                        |
|               | Consolidated Balance Sheets  at March 31, 2003 (unaudited) and December 31, 2002                       |
|               |                                                                                                        |
|               | Consolidated Statements  of Operations (unaudited) for the Three Months ended March 31, 2003 and  2002 |
|               |                                                                                                        |
|               | Consolidated Statements  of Cash Flows (unaudited) for the Three Months ended March 31, 2003 and  2002 |
|               |                                                                                                        |
|               | Notes to  Consolidated Financial Statements                                                                 |
|               |                                                                                                        |
| Item  2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                 |
|               |                                                                                                        |
| Item  3.           | Quantitative  and Qualitative Disclosures About Market Risk                                                 |
|               |                                                                                                        |
| Item 4.            | Controls and Procedures                                                                                     |
|               |                                                                                                        |
| **PART II:**       | **OTHER INFORMATION**                                                                                       |
|               |                                                                                                        |
| Item  1.           | Legal Proceedings                                                                                           |
|               |                                                                                                        |
| Item 6.            | Exhibits and Reports  on Form 8-K                                                                           |
|               |
| **SIGNATURES**     |
|               |
| **CERTIFICATIONS** |
|               |
| **EXHIBIT  INDEX** |

 

2

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**PART I. FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**NANOGEN, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands, except share data)**

** **
|                                                                                                                                                                                                 |   | **March 31,  2003** |   | **December  31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                                                                                                                                                                                 |   | **(unaudited)**     |   |                    |   |
| **ASSETS**                                                                                                                                                                                           |   |                |   |                    |   |
| Current assets:                                                                                                                                                                                      |   |                |   |                    |   |
| Cash and cash  equivalents                                                                                                                                                                           |   | $                   | 11,686 |                    | $      | 9,353 |   |
| Short-term  investments                                                                                                                                                                              |   | 25,167              |   | 43,376                  |   |
| Receivables, net                                                                                                                                                                                     |   | 1,406               |   | 1,754                   |   |
| Inventories, net                                                                                                                                                                                     |   | 4,642               |   | 4,717                   |   |
| Other current  assets                                                                                                                                                                                |   | 1,530               |   | 1,781                   |   |
| Total current assets                                                                                                                                                                                 |   | 44,431              |   | 60,981                  |   |
|                                                                                                                                                                                                 |   |                |   |                    |   |
| Property and  equipment, net                                                                                                                                                                         |   | 4,855               |   | 4,982                   |   |
| Acquired  technology rights, net                                                                                                                                                                     |   | 4,294               |   | 4,544                   |   |
| Other assets,  net                                                                                                                                                                                   |   | 505                 |   | 789                     |   |
| Restricted cash                                                                                                                                                                                      |   | 64                  |   | 64                      |   |
|                                                                                                                                                                                                 |   | $                   | 54,149 |                    | $      | 71,360 |   |
|                                                                                                                                                                                                 |   |                |   |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        |   |                |   |                    |   |
|                                                                                                                                                                                                 |   |                |   |                    |   |
| Current  liabilities:                                                                                                                                                                                |   |                |   |                    |   |
| Accounts payable                                                                                                                                                                                     |   | $                   | 615    |                    | $      | 753 |   |
| Accrued  liabilities                                                                                                                                                                                 |   | 4,543               |   | 5,901                   |   |
| Deferred revenue                                                                                                                                                                                     |   | 359                 |   | 472                     |   |
| Current portion  of capital lease obligations                                                                                                                                                        |   | 825                 |   | 805                     |   |
| Total current  liabilities                                                                                                                                                                           |   | 6,342               |   | 7,931                   |   |
|                                                                                                                                                                                                 |   |                |   |                    |   |
| Capital lease  obligations, less current portion                                                                                                                                                     |   | 923                 |   | 1,134                   |   |
| Other long-term  liabilities                                                                                                                                                                         |   | 3,088               |   | 3,085                   |   |
| Total long-term  liabilities                                                                                                                                                                         |   | 4,011               |   | 4,219                   |   |
|                                                                                                                                                                                                 |   |                |   |                    |   |
| Minority  interest in consolidated subsidiary                                                                                                                                                        |   | 1,269               |   | 1,817                   |   |
|                                                                                                                                                                                                 |   |                |   |                    |   |
| Stockholders’  equity:                                                                                                                                                                          |   |                |   |                    |   |
| Convertible  preferred stock, $0.001 par value, 5,000,000 shares authorized; no shares  issued and outstanding at March 31, 2003 (unaudited) and  December 31, 2002                        |   | —              |   | —                  |   |
| Common stock,  $0.001 par value, 50,000,000 shares authorized; 22,053,701 and 21,981,115  shares issued and outstanding at March 31, 2003 (unaudited) and  December 31, 2002, respectively |   | 22                  |   | 22                      |   |
| Additional  paid-in capital                                                                                                                                                                          |   | 199,591             |   | 199,483                 |   |
| Accumulated  other comprehensive income                                                                                                                                                              |   | 317                 |   | 4,926                   |   |
| Deferred  compensation                                                                                                                                                                               |   | (142                | )      | (156                    | )      |
| Notes receivable  from officers                                                                                                                                                                      |   | —              |   | (513                    | )      |
| Accumulated  deficit                                                                                                                                                                                 |   | (156,339            | )      | (145,659                | )      |
| Treasury stock,  at cost, 500,189 and 366,857 shares at March 31, 2003 (unaudited) and  December 31, 2002, respectively                                                                              |   | (922                | )      | (710                    | )      |
| Total stockholders’  equity                                                                                                                                                                     |   | 42,527              |   | 57,393                  |   |
|                                                                                                                                                                                                 |   | $                   | 54,149 |                    | $      | 71,360 |   |

 

See accompanying notes

 

3

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**NANOGEN, INC.**

## **CONSOLIDATED STATEMENTSOF OPERATIONS**

**(unaudited)**

**(in thousands, except per share data)**

 
|                                                                            |   | **Three  months ended March 31,** |    |
|---------------------------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                                            |   | **2003**                          |    | **2002** |   |
|                                                                            |   |                              |    |   |   |
| Revenues:                                                                       |   |                              |    |   |   |
| Product sales                                                                   |   | $                                 | 228     |   | $ | 812 |   |
| Sponsored  research                                                             |   | 375                               |    | 313 |   |
| Contract and  grant                                                             |   | 597                               |    | 408 |   |
| Total revenues                                                                  |   | 1,200                             |    | 1,533 |   |
|                                                                            |   |                              |    |   |   |
| Operating  expenses:                                                            |   |                              |    |   |   |
| Cost of product  sales                                                          |   | 274                               |    | 557 |   |
| Research and  development                                                       |   | 4,710                             |    | 4,863 |   |
| Selling, general  and administrative                                            |   | 4,066                             |    | 4,602 |   |
| Litigation and  settlement of patent matter                                     |   | —                            |    | 370 |   |
| Total operating  expenses                                                       |   | 9,050                             |    | 10,392 |   |
| Loss from  operations                                                           |   | (7,850                            | )       | (8,859 | ) |
|                                                                            |   |                              |    |   |   |
| Interest income,  net                                                           |   | 195                               |    | 760 |   |
| Other income                                                                    |   | 27                                |    | 6 |   |
| Loss on sale of  investments                                                    |   | (3,600                            | )       | — |   |
| Minority  interest in loss of consolidated subsidiary                           |   | 548                               |    | 561 |   |
| Net loss                                                                        |   | $                                 | (10,680 | ) | $ | (7,532 | ) |
|                                                                            |   |                              |    |   |   |
| Net loss per  share – basic and diluted                                    |   | $                                 | (0.50   | ) | $ | (0.35 | ) |
|                                                                            |   |                              |    |   |   |
| Number of shares  used in computing net loss per share – basic and diluted |   | 21,540                            |    | 21,620 |   |

 

See accompanying notes.

 

4

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**NANOGEN, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

**(in thousands)**

 
|                                                                                          |   | **Three  months ended March 31,** |    |
|-----------------------------------------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                                                          |   | **2003**                          |    | **2002** |   |
| **Operating activities:**                                                                     |   |                              |    |   |   |
| Net loss                                                                                      |   | $                                 | (10,680 | ) | $ | (7,532 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                  |   |                              |    |   |   |
| Depreciation and  amortization                                                                |   | 980                               |    | 961 |   |
| Amortization  related to short-term investments                                               |   | 53                                |    | 4 |   |
| Stock-based  compensation expense                                                             |   | 9                                 |    | 22 |   |
| Interest  capitalized on notes receivables from officers                                      |   | —                            |    | (14 | ) |
| Minority  interest in loss of consolidated subsidiary                                         |   | (548                              | )       | (561 | ) |
| Loss (gain) on  sale of short-term investments                                                |   | 3,579                             |    | (18 | ) |
| Changes in  operating assets and liabilities:                                                 |   |                              |    |   |   |
| Receivables                                                                                   |   | 349                               |    | 2,095 |   |
| Inventories                                                                                   |   | 75                                |    | (1,191 | ) |
| Other assets                                                                                  |   | 252                               |    | 707 |   |
| Accounts payable                                                                              |   | (138                              | )       | (216 | ) |
| Accrued  liabilities                                                                          |   | (780                              | )       | (1,114 | ) |
| Deferred revenue                                                                              |   | (113                              | )       | (64 | ) |
| Net cash used in  operating activities                                                        |   | (6,962                            | )       | (6,921 | ) |
|                                                                                          |   |                              |    |   |   |
| **Investing activities:**                                                                     |   |                              |    |   |   |
| Purchase of  short-term investments                                                           |   | (1,551                            | )       | (4,321 | ) |
| Proceeds from  sale and maturities of short-term investments                                  |   | 11,439                            |    | 8,511 |   |
| Purchase of  equipment                                                                        |   | (430                              | )       | (60 | ) |
| Purchase of  patents and technology rights                                                    |   | (3                                | )       | (225 | ) |
| Net cash  provided by investing activities                                                    |   | 9,455                             |    | 3,905 |   |
|                                                                                          |   |                              |    |   |   |
| **Financing activities:**                                                                     |   |                              |    |   |   |
| Principal  payments on capital lease obligations                                              |   | (240                              | )       | (443 | ) |
| Issuance of  common stock, net of repurchases                                                 |   | —                            |    | 201 |   |
| Net cash used in  financing activities                                                        |   | (240                              | )       | (242 | ) |
| Effect of  exchange rate changes                                                              |   | 80                                |    | (71 | ) |
| Net increase  (decrease) in cash and cash equivalents                                         |   | 2,333                             |    | (3,329 | ) |
| Cash and cash  equivalents at beginning of period                                             |   | 9,353                             |    | 10,455 |   |
| Cash and cash  equivalents at end of period                                                   |   | $                                 | 11,686  |   | $ | 7,126 |   |
|                                                                                          |   |                              |    |   |   |
| **Supplemental disclosure of cash  flow information:**                                        |   |                              |    |   |   |
| Interest paid                                                                                 |   | $                                 | 52      |   | $ | 39 |   |
| **Supplemental schedule of noncash  investing and financing activities:**                     |   |                              |    |   |   |
| Equipment  acquired under capital leases                                                      |   | $                                 | 49      |   | $ | 2 |   |
| Unrealized loss  on short-term investments                                                    |   | $                                 | 4,689   |   | $ | 500 |   |
| Accrued fee for  purchase of technology rights                                                |   | $                                 | —  |   | $ | 225 |   |
| Acquisition of  treasury stock in exchange for cancellation   of officer note receivable |   | $                                 | 212     |   | $ | — |   |
| Common stock  issued in connection with employee benefit plan, net of forfeitures             |   | $                                 | (3      | ) | $ | 95 |   |
| Common stock  issued to employees, accrued in prior period                                    |   | $                                 | 115     |   | $ | — |   |
| Repayment of  note receivable                                                                 |   | $                                 | 300     |   | $ | — |   |

 

See accompanying notes.

 

5

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**NANOGEN, INC.**

**Notes to Consolidated Financial Statements**

**(unaudited)**

**March31, 2003**

 

**1.****              Basis of Presentation**

 

The accompanying unaudited consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, they do not includeall of the information and disclosures required by accounting principlesgenerally accepted in the United States of America for complete financialstatements.  The consolidated balancesheet as of March 31, 2003, consolidated statements of operations for the threemonths ended March 31, 2003 and 2002, and the consolidated statements of cashflows for the three months ended March 31, 2003 and 2002 are unaudited, butinclude all adjustments (consisting of normal recurring adjustments) which theCompany considers necessary for a fair presentation of the financial position,results of operations and cash flows for the periods presented.  The results of operations for the threemonths ended March 31, 2003 shown herein are not necessarily indicative of theresults that may be expected for the year ending December 31, 2003.

 

For more complete financial information, thesefinancial statements, and notes thereto, should be read in conjunction with theaudited consolidated financial statements for the year ended December 31, 2002included in the Nanogen, Inc. Annual Report on Form 10-K for the year endedDecember 31, 2002, filed with the Securities and Exchange Commission.

 

***Net Loss per Share***

 

The Company computes net loss pershare in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 128, “Earnings per Share.”  Under the provisions of SFAS No. 128, basicnet income (loss) per share is computed by dividing the net income (loss)available to common stockholders for the period by the weighted average numberof common shares outstanding during the period.  Diluted net income (loss) per share is computed by dividing thenet income (loss) for the period by the weighted average number of commonshares outstanding during the period and dilutive common shares outstandingcomputed using the treasury stock method. The weighted average common shares outstanding during the period doesnot include those shares issued pursuant to the exercise of stock options priorto vesting and shares issued under the Company’s 401K benefit plan prior tovesting.  Due to the losses incurred bythe Company during the three months ended March 31, 2003 and 2002, common stockequivalents resulting from the assumed exercise of outstanding stock optionsand warrants have been excluded from the computation of diluted net loss pershare as their effect would be anti-dilutive.

 

***Recent Accounting Pronouncements***

 

In June 2002, theFinancial Accounting Standards Board (“FASB”) issued Statement No. 146, or SFASNo. 146, “Accounting for Costs Associated with Exit or Disposal.”  SFAS No. 146 addresses financial accountingand reporting for costs associated with exit or disposal activities andnullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in a Restructuring).”  The principal difference between Statement146 and Issue 94-3 relates to Statement 146’s requirements for recognition of aliability for a cost associated with an exit or disposal activity.  Statement 146 requires that a liability fora cost associated with an exit or disposal activity be recognized when theliability is incurred.  Under Issue94-3, a liability for an exit cost as generally defined in Issue 94-3 wasrecognized at the date of an entity’s commitment to an exit plan.  The provisions of this Statement 146 areeffective for exit or disposal activities that are initiated after December 31,2002, with early application encouraged. The adoption of SFAS No. 146 did not have a material impact on theconsolidated financial statements.

 

In December 2002, theFASB issued Statement No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure” to provide alternative methods oftransition for a voluntary change to the fair value based

 

6

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method of accounting for stock-based employee compensation.  In addition, this Statement amends thedisclosure requirements of Statement 123 to require prominent disclosures inboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method on reportedresults.  The adoption of these standards did not have a material impact on theCompany’s results of operations and financial position.

 

As permitted by SFAS No. 123, the Company has electedto follow Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees,” and related Interpretations (“APB 25”), in accounting forits employee stock options. Under APB 25, when the exercise price of theCompany’s employee stock options is equal to or exceeds the fair value of theunderlying stock on the date of grant, no compensation expense is recognized.

 

Adjusted pro forma information regarding net loss isrequired by SFAS 123 and has been determined as if the Company had accountedfor its employee stock options under the fair value method of SFAS 123. Thefair value for these options was estimated at the date of grant using theBlack-Scholes valuation model for option pricing with the following assumptionsfor three months ended March 31, 2003 and 2002, respectively: a risk-freeinterest rate of 3.0% and 5.0%, respectively, a dividend yield of zero; volatilityfactors of the expected market price of the Company’s common stock of 84% and74%, respectively, and a weighted average expected life of the option of fiveyears.  For purposes of adjusted proforma disclosures, the estimated fair value of the options is amortized toexpense over the vesting period.  TheCompany’s adjusted pro forma information is as follows (in thousands):

 

|                                   |   | **Three months ended March 31,** |    |
|----------------------------------------|--------|---------------------------------------|---------|
|                                   |   | **2003**                              |    | **2002** |   |
| Adjusted pro  forma net loss           |   | $                                     | (11,677 | ) | $ | (9,280 | ) |
| Adjusted pro  forma net loss per share |   | $                                     | (0.54   | ) | $ | (0.43 | ) |

 

The pro forma effect on net loss for three monthsended March 31, 2003 and 2002 is not necessarily indicative of potential proforma effects on results for future years.

 

***Reclassification***

 

Certain prior period amountshave been reclassified to conform to current period presentation.

 

**2.****              Inventories**

 

Inventories consist of thefollowing (in thousands):

 

|                      |   | **March 31,  2003** |       | **December  31,  2002** |       |
|---------------------------|--------|---------------------|------------|-------------------------|------------|
|                      |   | **(unaudited)**     | ** ** |                    | ** ** |
| Raw materials             |   | $                   | 1,420      |                    | $          | 1,062 |   |
| Work in process           |   | 1,762               |       | 1,485                   |       |
| Finished goods            |   | 4,028               |       | 4,428                   |       |
|                      |   | 7,210               |       | 6,975                   |       |
| Reserve for  obsolescence |   | (2,568              | )          | (2,258                  | )          |
|                      |   | $                   | 4,642      |                    | $          | 4,717 |   |

 

Finished goods includes$2.5 million and $3.2 million of NanoChip® Molecular Biology Workstations(“NanoChip® Workstations”) at March 31, 2003 and December 31, 2002,respectively, that are installed at customer sites where title has nottransferred to the customer.  Themajority of these instruments are placed at customer sites under developmentsite agreements.  Under thesearrangements, a NanoChip® Workstation is placed at a customer site for a periodnormally between six and nine months for the purpose of developing content andoptimizing assays which may result in the creation or enhancement ofintellectual property that the Company may license in the future.

 

7

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The customer has the option to purchase the NanoChip® Workstationduring the period of the arrangement or at its expiration.  The Company provides warranty for theseNanoChip® Workstations as well as insures them during thedevelopment site period.  Developmentsite customers are normally required to purchase any cartridges to be used onthe instrument from the Company during the development site period.  As of March 31, 2003, the Company had atotal of twenty-nine NanoChip® Workstations under agreements wherebythe Company retains title to the Workstation. The Company classifies this inventory as consignment inventory andincludes this within finished goods. The Company accrues refurbishment costsfor each unit included in consignment inventory for the purpose of resale inthe event the unit is returned under this arrangement.  This reserve totaled $513,000 and $489,000at March 31, 2003 and December 31, 2002, respectively.  In addition, the Company has recorded areserve related to the older production units which may be deemed obsolete ormay be sold to the customer at a discount due to the depreciation of the unitduring the development site period. This reserve totaled $1.6 million at March 31, 2003 and December 31,2002.

 

The Company’s manufacturing agreement with Hitachi,Ltd. (“Hitachi”) requires that the Company provide annual purchase commitments to Hitachi for NanoChip®Workstations.  As of March 31, 2003, theCompany had commitments to purchase approximately $2.4 million in NanoChip®Workstations through July 31, 2003.  AtMarch 31, 2003, the inventory under our purchase commitment with Hitachi iswithin our expected usage levels based upon current and estimated future demands.

 

**3.****              Licensed Technology**

 

The Company has acquired various licenses totechnologies which are incorporated into certain of the Company’s currentproducts or products under development. The Company capitalizes the cost (which includes cash and/or equityconsideration) in conjunction with the acquisition of these licenses andamortizes the cost over the expected life of the product.  In June 2002, the Company issued 254,151shares of the Company’s common stock valued at $750,000, based on the closingprice of the Company’s stock at the effective date, to a licensor inexchange for license rights in a private stock transaction.  In April 2002, the Company issued a warrantexercisable through April 12, 2007 to purchase 50,000 shares of the Company’scommon stock at a per share price of $4.10, the fair market value on theeffective date of the agreement.  Thevalue of the warrant was determined to be $122,000 using the Black-Scholesvaluation model.  Assumptions used indetermining the value of the warrant were as follows: dividend yield of 0%,expected volatility of 65%, risk-free interest rate of 5.5%, expected life of 5years, stock price of $4.10 per share, and an exercise price of $4.10 pershare.  The warrant has a term of fiveyears, and was issued in return for license rights.

 

**4.****              Comprehensive Loss**

 

SFAS No. 130, “Reporting Comprehensive Income,”requires the Company to report, in addition to net income (loss), comprehensiveincome (loss) and its components.   Asummary is as follows (in thousands):

 
|                                    |   | **Three months ended March 31,** |    |
|-----------------------------------------|--------|---------------------------------------|---------|
|                                    |   | **2003**                              |    | **2002** | ** ** |
| Comprehensive loss:                     |   |                                  |    |   |   |
| Net unrealized loss                     |   | $                                     | (4,689  | ) | $ | (500 | ) |
| Foreign currencytranslation  adjustment |   | 80                                    |    | 147 |   |
| Net loss                                |   | (10,680                               | )       | (7,532 | ) |
| Comprehensive loss                      |   | $                                     | (15,289 | ) | $ | (7,885 | ) |

 

8

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**5.****              Collaborative Alliances**

 

***Hitachi, Ltd.***

 

Manufacturing Agreement

 

In January 2000, the Company executed an agreementwith Hitachi, Ltd., effective as of December 15, 1999, for the full-scale commercial manufacturing and distributionof the NanoChip® Molecular Biology Workstation in specified research markets.Hitachi, Ltd.’s Instrument Group provides technology and technical support toaid in the manufacturing of the NanoChip® Molecular Biology Workstation’s components.

 

Pursuant to the agreement, Hitachi, Ltd. has the rightto be the sole distributor of NanoChip® Molecular Biology Workstations inJapan. Hitachi, Ltd. also has the non-exclusive right to distribute NanoChip®Cartridges in Japan.  Under this arrangement,the Company receives a royalty for NanoChip® Molecular Biology Workstationssold by Hitachi, Ltd. in Japan.  TheCompany retained the right to distribute, directly or through others, NanoChip®Molecular Biology Workstations outside of Japan.  In addition, the Company manufactures NanoChip® Cartridges at itsSan Diego, California facility for distribution worldwide.  The Company also retained the right to formother manufacturing and distribution agreements.

 

Pursuant to our manufacturing agreement with Hitachi,the Company is required to provide annual purchase commitments to Hitachi forNanoChip® Workstations.  As of March 31,2003, the Company had a commitment to purchase approximately $2.4 million inNanoChip® Workstations from Hitachi through July 31, 2003.

 

Research CollaborationAgreement

 

In July 2000, the Company executed a ten-yearagreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd. and Hitachi InstrumentsService Co. Ltd. of Japan (collectively, “Hitachi”) to develop, manufacture anddistribute additional potential products based on the parties’ proprietarytechnologies, potentially including, among other things, reduced-sizeinstruments for genetic testing, integrated amplification and point-of-caredetection.  The agreement provides thatthe parties will jointly determine which projects to prioritize over the termof the agreement. The agreement may be terminated before its expiration byeither party, subject to certain restrictions. Pursuant to the terms of the agreement, Hitachi and the Company each maycontribute, toward the research and development efforts of the Company, up to$28.5 million in cash over the ten-year period.  At a minimum, the Company is required to contribute on an annualbasis funding for its own general technology development in an amount equal toor greater than payments made by Hitachi. In addition, the Company is liable to repay to Hitachi fifty percent ofall funding provided by Hitachi over an indefinite period of time.  Repayment amounts are determined as a percentageof the Company’s gross NanoChip® Cartridge sales until the liability is paid infull. Furthermore, Hitachi made an equity investment in the Company bypurchasing 74,590 shares of the Company’s common stock worth approximately $2.0million pursuant to a private sale by the Company based on a per share price of$26.813 (the fair market value as of the signing date of the Hitachiagreement).  Hitachi has the right to bethe exclusive distributor of collaboration products in Japan and, based uponthe attainment of minimum sales targets to be mutually agreed upon, in otherAsian countries.  The Company retainsthe exclusive right to distribute collaboration products outside of thesecountries.

 

Sponsored research revenue recognized under thisagreement totaled $375,000 and $313,000 for the three months ended March 31,2003 and 2002, respectively. In accordance with SFAS No. 68, the Companyrecords sponsored research revenue under this arrangement as expenses areincurred not exceeding scheduled payments under the agreement.  The Company records a long-term liabilityfor fifty percent of the funds received from Hitachi upon the receipt of suchfunds.  The amount owed to Hitachi forproceeds received under this agreement was $3.0 million at March 31, 2003 and December31, 2002.  The current portion of thelong-term liability remains immaterial as payment amounts due under thisobligation are determined as a percentage of the Company’s gross 

 

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NanoChip® Cartridge sales which have not been significant to date.  As such, the Company has classified theentire balance of this liability as long-term.

 

Service Agreement

 

In October 2000, the Company entered into an agreementwith Hitachi for the service by Hitachi of the NanoChip® Molecular BiologyWorkstations in the United States after their sale or placement by the Companywith the Company’s customers.  TheCompany pays an agreed-upon amount (as specified in the agreement) to Hitachifor annual service for each Workstation covered under the agreement.  Nanogen amortizes the cost of the warrantyagreement over the service period.  Asthe Company provides the first year of warranty at no charge to the customer,the Company defers the portion of the Workstation sale revenue that relates tothe warranty agreement.  This deferredrevenue is then amortized into revenue ratably over the annual serviceperiod.  In subsequent years, thecustomer can pay an annual service fee to the Company and the Company will inturn pay Hitachi the annual service amount as specified in the agreement.  The amount charged to the customer by theCompany is based upon the cost of the service (i.e. the payment to Hitachi)plus an industry accepted profit margin for comparable service on similar typesof products.  Both the service revenueand the service expense are amortized ratably over the service period,generally one year.

 

***Aventis Research and Technologies***

 

In June 2001, the Companyentered into agreements with Hoechst AG (“Aventis”) to create a new company,Nanogen Recognomics GmbH (“Nanogen Recognomics”).  Nanogen Recognomics was established to develop new products andapplications for the NanoChip® System. Nanogen Recognomics is sixty percent owned by the Company and fortypercent owned by Aventis and is based in Frankfurt, Germany.  Aventis provided the first $5 million offunding for the operations of Nanogen Recognomics and also contributedintellectual property in the form of eighteen patents.  The Company is also required to spend an aggregateof $5.5 million, at the rate of $1.1 million per year beginning April 1, 2001,for its own general technology development which benefits the commercializationand development of potential Nanogen Recognomics products.  This funding is recorded as research anddevelopment expense in the Company’s statement of operations as incurred.  The amounts contributed by Aventis are spentby the joint venture and reported in the operating results of the jointventure.  Aventis has no furthercommitments to provide funding beyond the first five years of operation.  In addition, Nanogen Recognomics will ownseveral patent applications filed jointly by the Company and Aventis.  The Company has licensed certain aspects ofits NanoChip® technology to Nanogen Recognomics and will seek to commercializenew products and applications developed by Nanogen Recognomics.  Aventis retains the right to utilize theformer Aventis patent portfolio in fields outside of Nanogen Recognomics.  In conjunction with the agreement to formNanogen Recognomics, the Company issued a warrant to Aventis to purchase315,863 shares of common stock exercisable through July 17, 2006 at an agreedupon price of $9.828 per share.  Thevalue of this warrant, as determined by the Black-Scholes valuation model, was$1.2 million, is included in other assets in the accompanying consolidatedfinancial statements and is being amortized over a two and a half year period,the estimated period for which the $5 million in funding will provide foroperating expenses.  Assumptions used indetermining the value of the warrant were as follows: dividend yield of 0%,expected volatility of 70%, risk-free interest rate of 6.5%, expected life of 5years, stock price of $6.79 per share, and an exercise price of $9.828 pershare.  In the event Nanogen Recognomicsshould run out of funds, the Company is required pursuant to the agreement totake over wind-down costs and Nanogen may restructure Nanogen Recognomics tohold the original patents contributed by Aventis and any jointly ownedpatents.  Such a restructured companywill collect royalties, if any, and pay the equity owners accordingly.  Our exclusive commercialization license willcontinue for 10 years after restructuring.

 

The results of operationsfor Recognomics are fully consolidated in the Company’s financialstatements.  The total operating loss ofRecognomics is reflected as a reduction of the “minority interest inconsolidated subsidiary” liability account and totaled $548,000 and $561,000for the three months ended March 31, 2003 and 2002, respectively.

 

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**6.****              Litigation**

 

In September 2002, the Company entered into a settlement agreement withCombiMatrix Corp. (“CombiMatrix”) and Dr. Donald Montgomery concluding pendinglitigation in the U.S. District Court for the Southern District ofCalifornia.  Pursuant to the settlementagreement, Nanogen agreed to drop its claims against CombiMatrix and Dr.Montgomery that include certain causes of action relating to U.S. patent Nos.6,093,302 and 6,280,595 (the “patented technology”) that were assigned by Dr.Montgomery, an ex-Nanogen employee, to CombiMatrix in 1995 and assertionsrelating to other matters. In exchange, CombiMatrix agreed to pay $1.0 millionas a reimbursement of legal costs; issue 4,016,346 shares of CombiMatrixtracking common stock that as of December 18, 2002 became publicly tradable onthe Nasdaq National Market and were initially valued upon receipt at $10.8million, which represents seventeen and one-half percent (17.5%) of itsoutstanding common stock; and make royalty payments of twelve and one-halfpercent (12.5%) on sales of products by either CombiMatrix or its affiliatesthat incorporate the patented technology. Of the $1.0 million due the Company, $500,000 was paid in October 2002and the remaining $500,000 is due by September 2003.  Also, as part of the settlement agreement, CombiMatrix and Dr.Montgomery agreed to drop their counterclaims against Nanogen and CombiMatrixretained sole ownership of the patented technology.  In February 2003, the Company sold 3,000,000 sharesof CombiMatrix common stock for net proceeds totaling $4.5 million andrecognized a realized loss of approximately $3.6 million during the threemonths ended March 31, 2003.

 

The costs associated with the litigation andsettlement of the CombiMatrix and Dr. Montgomery litigation patent mattertotaled approximately $370,000 for the three months ended March 31, 2002 and noexpenses of this type were recorded in 2003. A receivable totaling $500,000 has been recorded in the Company’sfinancial statements which represents the unpaid balance of the $1.0 millionsettlement as of March 31, 2003.

 

In December, 2002, Oxford Gene Technologies (“OGT”)filed a complaint against the Company in the United States District Court forthe District of Delaware claiming that Nanogen infringes U.S. Patent No.  6,054,270 (the “‘270 Patent”) entitled“Analyzing Polynucleotide Sequences.” In April 2003, Nanogen filed an answer to the complaint that denies thatit infringes the ‘270 Patent. Nevertheless, if the litigation continues, significant attorneys’ costsand fees could result.  Although it isNanogen’s position that OGT’s assertions of infringement have no merit, neitherthe outcome of the litigation nor the amount and range of potential fees canyet be assessed.  No assurances can begiven that the Company will prevail in the lawsuit or that it can successfullydefend itself against the claim and the Company may not prevail in the action,which could have a material adverse effect on the Company.

 

**7.****              StockTransaction**

 

In January 2003, theCompensation Committee of the Board of Directors approved the issuance ofcommon stock pursuant to the Company’s Stock Bonus Plan.  During the three months ended March 31,2003, the Company issued 73,119 shares of common stock under the Plan valued atapproximately $115,000 based on the value of the shares at the date ofissuance.

 

**8.****              Related PartyTransactions**

 

In December 2002, the Company entered into a separationagreement with its then Chief Executive Officer.  Under the terms of theagreement, the Company made a net severance payment of $58,000 in January 2003to settle all outstanding obligations between the two parties, includingindebtedness to the Company amounting to $167,000.

 

Also in December 2002, Nanogen’s then Presidentresigned effective in January 2003. In connection with the former President’sresignation, the Company made a net payment of approximately $384,000 inJanuary 2003 to settle all outstanding obligations between the two parties,including indebtedness to the Company amounting to approximately $300,000.

 

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Mr. Birndorf, Chief Executive Officer, owned anaircraft which was leased by a local charter aircraft company. For the threemonths ended March 31, 2003, the Company paid approximately $25,000 to thelocal charter aircraft company for the Company’s use of Mr. Birndorf’s aircraftfor business related travel.  Mr.Birndorf receives $1,500 per hour of usage when his aircraft is leased tooutside parties. Mr. Birndorf received approximately $15,000 as a result of theCompany’s use of Mr. Birndorf’s aircraft during the three months ended March31, 2003.  The Company believes that theterms of the charter arrangements are no less favorable to the Company thanthose that could be obtained from unrelated third parties, based on review oflease fees published by other charter aircraft companies.

 

**9.****              SubsequentEvent**

 

In April 2003, the Company reduced its workforce byapproximately 20%. A severance charge of approximately $500,000 will berecognized in the second quarter of fiscal 2003 related to this event.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

This report includesforward-looking statements about our business and results of operations thatare subject to risks and uncertainties that could cause our actual results tovary materially from those reflected in the forward-looking statements.  These risks and uncertainties includepossible delays in the introduction of new products, customer acceptance ofexisting products, price competition, the actions of competitors, infringementof intellectual property rights and licenses of the Company or others, theeffects of government regulation, both foreign and domestic, availability offunded research and government contracts and grants, preservation of productiverelationships with our manufacturer and collaborator Hitachi and ourdistributors, ability to manage our capital resources and other factors. Wordssuch as “believes,” “anticipates,” “plans,” “estimates,” “future,” “could,”“may,” “should,” “expect,” “envision,” “potentially,” variations of such wordsand similar expressions are intended to identify such forward-lookingstatements.  The forward-lookingstatements contained in this Form 10-Q may include, but are not limited to,  statements about matters including thefollowing:  (i) the development of themarkets and demand for our products and services; (ii) our product developmentplans and anticipated activities designed to pursue these plans, includingcollaborations and other corporate partnering arrangements; (iii) our abilityto operate substantial revenues from sales of products and consumablecartridges and reagents and continuing revenues from reagent rental agreements;(iv) the ability of our product platform to affect the market and become anindustry standard; (v) our ability to generate license and other fee revenue inthe future; (vi) the amounts we invest in research and development activitiesin the future; (vii) future levels of selling, general and administrativeexpenses and other expenses associated with our business; (viii) future levelsof interest income; (ix) any amounts we may be able to realize from theliquidation of our investments, including our investments in short-termsecurities; (x) operating results of joint ventures and other corporatepartnering arrangements; (xi) the amounts and timing of our contractualobligations and capital commitments and (xii) our future capital needs and ourability to fund those needs. Factors that could cause or contribute to thesedifferences include those discussed below under the caption “Factors that MayAffect Results” and elsewhere in this Quarterly Report on Form 10-Q and whichare described in our Annual Report on Form 10-K for the year ended December 31,2002.  Readers are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date hereof.  We disclaim anyintent or obligation to update these forward-looking statements.

 

**Overview**

 

It is our goal to become a leading provider ofmolecular diagnostic tests and services. We integrate advanced microelectronics and molecular biology into a coretechnology platform with potentially broad and diverse commercialapplications.  Our primary areas offocus have been in genomics and biomedical research, medical diagnostics,biodefense, forensics and drug discovery. The Company’s current commercially available products include (1) theNanoChipâ Molecular BiologyWorkstation, an automated, multi-purpose instrument primarily used forDNA-based analyses, (2) the NanoChipâ Cartridge, whichincorporates the NanoChipâ ElectronicMicroarray and provides a flexible tool for the rapid identification andprecise analysis of biological test samples containing charged molecules, (3)various Analyte Specific Reagents (“ASRs”) for detecting gene mutations associatedwith diseases such as cystic fibrosis, Alzheimer’s disease and hereditaryhemochromotosis and (4) Assay ToolboxÔ, a productdesigned to help customers develop their own assays on the NanoChipâSystem.  The Company also has severalother ASRs and applications of its proprietary technology underdevelopment.  The Company providestechnical support and field applications assistance to its customers.

 

Since commencing operations in 1993, we have appliedsubstantially all of our resources to our research and developmentprograms.  We have incurred losses sinceinception and, as of March 31, 2003, had an accumulated deficit of $156.3million.  We expect to continue to incursignificant losses over at least the next few years as we attempt to furthercommercialize our products as well as expand the menu of applications for ourcurrent products.

 

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We introduced our first two products into themarketplace in 2000.  While werecognized revenue from product sales during the quarter ended March 31, 2003and the years ended December 31, 2002, and 2001, our main sources of revenuesduring these periods were payments under our sponsored research agreements,contracts and grants and, in 2002, a license fee valued at $10.8 millionreceived from a litigation settlement with CombiMatrix Corp.  We believe that in future periods, however, our revenue base willshift to being more product driven as certain research collaboration agreementsexpire and new products are introduced by us to the marketplace.  We believe our future operating results maybe subject to quarterly fluctuations due to a variety of factors, including,but not limited to, market acceptance of the NanoChip® System, other productscurrently being sold by the Company and potential products under development,the type of acquisition program our potential customers may choose, whether andwhen new products are successfully developed and introduced by us or ourcompetitors, and the achievement of milestones under our collaborativeagreements with Hitachi and various government agencies.  The recognition of revenue under contracts,grants and sponsored research agreements will be subject to significantfluctuations in both timing and amount and therefore our results of operationsfor any period may not be comparable to the results of operations for any otherperiod.

 

***Critical Accounting Policies and Estimates***

 

This Management’s Discussion and Analysis of FinancialCondition and Results of Operations discusses our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these financial statements requires us to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. On an on-going basis, we evaluate our estimates andjudgments, including those related to bad debts, inventories, investments,intangible assets, service obligations and contingencies.  We base our estimates and judgments onhistorical experience and on various other factors that we believe to be reasonableunder the circumstances.  Actual resultsmay differ from these estimates under different assumptions or conditions.

 

We believe the following critical accounting policies,among others, affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements:

 

*Revenuerecognition*

 

We generate product revenue by the sale of ourcommercial products and services under various sales programs to the end useror through distribution channels.  Werecognize revenue in accordance with Staff Accounting Bulletin 101 “RevenueRecognition in Financial Statements” and record revenues as follows:

 

We offer our NanoChip® Molecular Biology Workstationsunder various commercial programs such as direct sales, lease arrangements,reagent rental programs and cost-per-test agreements.  We also offer our Workstations to customers under developmentsite programs that may result in one of the above commercial transactions.  We sell our Workstations direct to the enduser and to distributors. Revenue from the sale of consumables is recognizedupon shipment (f.o.b. shipping point) as we do not sell consumables with aright of return.

 

Revenue from the direct sale of NanoChip® MolecularBiology Workstations is recognized following receipt of a purchase order,shipment (f.o.b. shipping point) of product, and transfer of title when solddirectly to the end user or to a distributor. In transactions where a right-of-return exists, revenue is deferreduntil acceptance has occurred and the period for the right-of-return haslapsed.  The NanoChip® Molecular BiologyWorkstation is sold with a one-year warranty contract.  The fair value of the warranty is recorded asdeferred revenue and recognized ratably over the warranty period included in thecustomer contract.  The fair value ofthe warranty is based on the renewal price paid by the same customer.  This renewal price for the maintenancecontract is consistent for all customers. We provide for the estimated cost of product warranty at the timerevenue is recognized.

 

We also recognize revenue from the sale of ourNanoChip® System under reagent rental and cost-per-test transactions wherebycustomers pay a premium for our consumable products (NanoChip® Cartridges orASRs) over a number of years that is intended to cover the sales price of theNanoChip® Workstation, consumables and warranty.  Under a reagent rental transaction, the customer commits topurchasing a fixed minimum number of

 

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consumable products on a periodic basis for a specified period of time(i.e. a certain number of cartridges for a certain number of years).  Revenue for the Workstation, consumables andwarranty under reagent rental transactions is recognized as consumable productsare shipped, over a period of generally two to five years, depending on thespecific customer arrangement as they may vary by customer.  We reclassify the recorded value of theWorkstation from inventory to fixed assets, recognizing the depreciationexpense as cost of sales ratably over the period of the arrangement.  Under a cost-per-test transaction, thecustomer agrees to purchase a certain number of consumable products on aperiodic basis determined by the customer’s volume of reported test results (tothird parties) from the use of our consumable products.  We recognize revenue under this type oftransaction at the time we receive evidence of the customer’s test resultsreported to third parties.  Under thesearrangements, we provide product warranty coverage for the Workstation over theperiod of the contract.  Under both ofthese commercial transactions, the fair value of the warranty is recognizedratably over the warranty period included in the customer contract.  The cost of sales related to the consumablesis recorded in line with the revenue (i.e. as consumables are shipped orconsumed, depending on the terms of the contract).

 

We also place our NanoChip® Molecular BiologyWorkstations at customer sites under programs, such as development sitearrangements, where title of the NanoChip® Workstation does not transfer to thecustomer.  No revenues are recognized atthe time of placement under these agreements. These arrangements are for a period normally between six and nine monthsfor the purpose of developing content and optimizing assays that may result inthe creation or enhancement of intellectual property that we may license in thefuture. In addition, a primary intent of the program is for the customer topurchase the NanoChip® Workstation during the period of the arrangement or atits expiration.  We provide a warrantyfor these NanoChip® Workstations as well as insure them during thedevelopment site period.  Warrantyexpense is recorded ratably over the period of the arrangement within selling,general, and administrative (SG&A) expenses.  Development site customers are normally required to purchase anyconsumables to be used on the instrument from us during the development siteperiod.  We classify this inventory asconsignment inventory and include this within finished goods.  We record a reserve for the refurbishmentcosts, recorded within SG&A, for each unit included in consignmentinventory for the purpose of resale in the event the unit is returned underthis arrangement.  This reserve totaledapproximately $513,000 and $489,000 at March 31, 2003 and December 31, 2002,respectively, and is included in accrued liabilities.  In addition, we have recorded a reserve related to the olderproduction units that may be deemed obsolete or sold to the customer at adiscount due to the age of the unit during the development site period.  Transactions under these types of programsdo not result in the recognition of revenue. However, if the customer opts to purchase the NanoChip® Workstation at anytime, sales revenue is recognized upon receipt of a purchase order.  Cost of sales for the Workstation isprovided for at the time revenue is recognized.  For the three months ended March 31, 2003, we converted one****developmentsite agreement. There were no development site agreement conversions during thethree months ended March 31, 2002.

 

Workstations sold to distributors are sold outrightwith title transferring at point of shipment (i.e., f.o.b. shipping point)without a right of return. Workstations are sold at a discount to the standardsales price (but not below the cost of manufacturing the instrument) andwithout warranty coverage.

 

Sales revenue is subject to fluctuation due to thetype of acquisition program our customers may choose.  Sponsored research and contract and grant revenue are generallyrecorded as the costs and expenses to perform the research are incurred.  Under certain arrangements revenue isrecorded ratably over the term of the arrangement as funding is provided forcontractually on a scheduled basis. Payments received in advance under these arrangements are recorded asdeferred revenue until the expenses are incurred.  Continuation of certain sponsored research and contracts andgrants are dependent upon our achieving specific contractual milestones.

 

License fees include nonrefundable fees generated fromthe licensing of the Company’s technology. Revenue is recognized immediately when the Company has no furtherobligation to perform and collections are reasonably assured.

 

*Bad debts*

 

We maintain allowances for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. We record additions to our reserve based on specific analysis of eachcustomer’s balance due us.  If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances would be required.

 

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* *

*Inventory*

 

We reduce the carrying value of our inventory,including NanoChip® Molecular Biology Workstations placed under developmentsite arrangements, for estimated obsolescence or non-marketability afterconsidering future purchase commitments and based upon assumptions about futuredemand and market conditions. If actual future demand or market conditions areless favorable than those projected by us, additional inventory write-downs maybe required.

* *

*Intangible Assets*

 

We have intangible assets related to acquiredtechnology rights.  The determination ofrelated estimated useful lives and whether or not these assets are impairedinvolves significant judgments.  Changesin strategy and/or market conditions could significantly impact these judgmentsand require adjustments to recorded asset balances.

** **

**Resultsof Operations**

 

*Revenues*

 

**Product Revenues. **Forthe three months ended March 31, 2003, sales totaled $228,000 compared to $812,000 for the three months ended March 31, 2002.Product sales revenue during the three months ended March 31, 2003 included the sale of one partial NanoChip® Molecular Biology Workstation as well as salesof NanoChip® Cartridges, reagentsand warranty revenue. For the three months ended March 31, 2002, sales revenue included sales of five NanoChipâ Molecular Biology Workstations in addition to sales of NanoChipâ Cartridges and warranty revenue. All revenue recorded related to sales of our NanoChip® MolecularBiology Workstation resulted from outright sales transactions where title ofthe instrument passed to the customer. We offer our products to customers under several different types ofacquisition programs, some of which pass title of the instrument to thecustomer and some of which do not pass title to the customer.  Our sales revenue may vary from year to yeardue to, among other things, the types of acquisition programs our potentialcustomers may choose.

 

**Sponsored Research.**  For the three months ended March 31, 2003,revenues from sponsored research totaled$375,000 compared to $313,000 for the three months ended March 31, 2002.  Revenues are primarily recorded underthese arrangements as expenses are incurred. Payments received in advance under these arrangements are recorded asdeferred revenue until the expenses are incurred.  Sponsored research revenue recognized during the three monthsended March 31, 2003 and 2002 primarily represent revenue earned in connectionwith our development agreement entered into in July 2000 with Hitachi.  We are currently on schedule with projectmilestones with the Hitachi development agreement and expect to continue toreceive funding under this collaboration pursuant to terms of the agreement.

 

**Contracts and Grants.**  We fund some of our research and developmentefforts through contracts and grants awarded by various federal and stateagencies.  Revenues are recognized underthese contracts and grants as expenses are incurred, and totaled $597,000 and$408,000 for the three months ended March 31, 2003 and 2002, respectively.

 

**Cost of Product Sales and Gross Margins.**Costof product sales totaled $274,000 for the three months ended March 31, 2003,compared to $557,000 for the three months ended March 31, 2002.  The gross margin on product sales revenuewas a negative 20% for the three months ended March 31, 2003 compared to apositive margin of 31% for the three months ended March 31, 2002.  Cost of product sales during the threemonths ended March 31, 2003 were adversely impacted by lower sales volume,underabsorbed overhead costs due to underutilized capacity, and manufacturingscrap as a result of lower yields on new products released intoproduction.  The cost per unit of ourproducts remains high, as our volume of production relative to the availablecapacity remains low.  As we are stillin the early stages of commercialization, we expect to continue to incursignificant costs associated with excess production capacity within ourmanufacturing facility in 2003.  Inaddition to underabsorbed overhead costs, cost of product sales for the periodended March 31, 2002 was further impacted by a reserve for obsolete inventorytotaling $278,000.  This reserve relatesprimarily to excess instrument parts and accessory items in our inventory thatcould potentially become obsolete prior to their consumption.  If necessary, these parts will be used asreplacement parts for Nanogen Systems located both internally and at customersites. Gross margins during the period ended March 31, 2002

 

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were further impacted by sales of NanoChip® Workstations to certain customers under variousdiscount programs and by sales to distributors, which are generally at adiscount.  Gross margins in futureperiods may be further impaired by minimum product royalties or potentialadjustments made to reflect the impairment of intangible assets related toproducts sold.

 

**Research and Development Expenses.**  For the three months ended March 31, 2003and 2002, research and development expenses totaled $4.7 million compared to $4.9 million, respectively.  During these periods, research anddevelopment expenses included the cost of salaries and benefits for scientific,engineering and operations personnel, costs associated with improving andrefining our current products as well as development of potential new productsand protocols, lab supplies, consulting, travel, facilities, and otherexpenditures associated with our research and product developmentactivities.  For the three months endedMarch 31, 2003 research and development activities primarily related to thedevelopment of new ASRs.  We anticipatethat we will continue to invest in research and product development atapproximately this same level for the foreseeable future.

 

**Selling, General and Administrative Expenses**.  For the three months ended March 31, 2003and 2002, selling, general and administrative expenses totaled $4.1 million and$4.6 million, respectively. Selling, general and administrative expensesinclude salaries, benefits, consulting, travel and other expenditures relatedto executive, legal, finance, human resources, sales and marketingpersonnel.  In addition, these expensesinclude costs related to enhancing and maintaining our intellectual propertyportfolio.  The decline in selling,general, and administrative expense for the three months ended March 31, 2003as compared to the same period during the prior year is primarily the result ofdecreased expenditures associated with the launch of products.  Selling, general and administrative expensesare expected to continue at the current level for the foreseeable future as wecontinue to market and sell our current and potential future products.

 

**Litigation and Settlement of Patent Matter, Net.** For the three months ended March 31, 2002,litigation and settlement of patent matter totaled $370,000.  There were no expenses of this type in2003.  These expenses related to adispute with CombiMatrix and Dr. Montgomery. As a settlement between all parties was reached in September 2002, therewere no expenses related to this matter in 2003.

 

**Interest Income, Net**.  For the three months ended March 31, 2003,net interest income totaled $195,000compared to $760,000 for the threemonths ended March 31, 2002.  Thedecrease in net interest income is a result of lower average cash andinvestment balances as well as lower yields on outstanding cash and investmentbalances during the three month period ending March 31, 2003 when compared tothe three months ended March 31, 2002. Based on the continued consumption of cash and short-term investments toaugment operating activities, we expect net interest income to decline during2003.

 

**Minority Interest in Loss of Consolidated Subsidiary. **We had losses relating toour majority-owned subsidiary, Nanogen Recognomics GmbH, of $548,000 for thethree months ended March 31, 2003 compared to $561,000 for the three monthsended March 31, 2002.  We expect toexperience continued losses with the majority-owned subsidiary similar tolevels incurred during 2002.  Theselosses are funded by the investment from minority interest investors and aretherefore offset against the minority interest balance in the respectivebalance sheet.  In June 2001, we enteredinto agreements with Aventis to create a new company, Nanogen Recognomics GmbH(“Nanogen Recognomics”).  NanogenRecognomics was established to develop new products and applications for theNanoChip® System.  Nanogen Recognomicsis sixty percent owned by us and forty percent owned by Aventis.

 

**Liquidityand Capital Resources**

 

At March 31, 2003, we had $36.9 million in cash, cashequivalents and short-term investments, compared to $52.7 million at December31, 2002.  The decrease is primarily dueto cash used in operations during the three months ended March 31, 2003totaling $7.0 million and realized and unrealized losses in short-term investmentsof approximately $8.3 million related primarily to CombiMatrix securities.  While the CombiMatrix securities areincluded within short-term investments, we expect significant market valuefluctuations in this investment that had a market value of approximately $2.0million at March 31, 2003.

 

Net cash used in operating activities was $7.0 millionand $6.9 million for the three months ended March 31, 2003 and 2002,respectively.  Cash used for operationsduring the three months ended March 31, 2003 was primarily

 

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related to costs associated with commercializing our products includingthe expansion, development and support of our sales and marketing organization;the procurement of inventory pursuant to our manufacturing arrangement withHitachi, Ltd; support of our continuing research and development effortsincluding development of the ASRs for the detection of mutations in the CFTRgene associated with cystic fibrosis, the ASRs for mutations in the HFE geneassociated with the hereditary hemochromotosis, and the other ASRs and otherproducts recently introduced by Nanogen; and legal fees relating toestablishing, maintaining and defending our intellectual property portfolio.

 

Net cash provided by investing activities was $9.5million and $3.9 million for the three months ended March 31, 2003 and 2002,respectively.  We purchase short-terminvestments in order to enhance the yield on our cash balances.  These securities mature from time to time orare sold to fund operating expenses.

 

We fund much of our equipment acquisitions andleasehold improvements through capital leasing facilities. We anticipate thatwe will continue to use capital equipment leasing or debt facilities to fundmuch of our equipment acquisitions and leasehold improvements. As of March 31,2003, we had approximately $1.0 million of available funding under ourequipment lease lines.

 

Our manufacturing agreement with Hitachi, Ltd.requires that we provide annual purchase commitments to Hitachi for NanoChip®Molecular Biology Workstations.  As ofMarch 31, 2003, the Company had commitments to purchase approximately $2.4million in NanoChip® Workstations through July 31, 2003.  At March 31, 2003, the inventory under ourpurchase commitment with Hitachi is within our expected usage levels based uponcurrent and estimated future demands.

 

We are a party to development site agreements withvarious entities and to license agreements under which we acquired rights topay license fees, annual minimum royalties or product royalties for any customer owned or licensedintellectual property used to develop any Nanogen commercial products. None ofthese agreements individually are considered material.

 

We are also party to transactions known as reagentrentals and cost-per-test agreements. Under these types of transactions, we place a workstation at a customersite with no upfront cost to the customer. The value of the instrument is typically recaptured through a contractedstream of future reagent sales, sold at a premium to cover the cost of thesystem.  Many of our reagent rentals andcost-per-test agreements entered into to date require customer acceptance ofour CFTR ASRs as a pre-condition to this commitment.  These reagent rentals and cost-per-test agreements might have anadverse impact on our short-term instrument sales revenue and cash flow as therevenues and cash received under these agreements are over the life of thecontract, as reagents are shipped to the customer. We expect that our existingcapital resources, combined with anticipated revenues from potential productsales, reagent rentals, leases or other types of acquisition programs for theNanoChip® System, sponsored research agreements, contracts and grants will besufficient to support our planned operations for at least one year from thedate of this filing at our current rate of expenditures.  This estimate of the period for which weexpect our available sources of liquidity to be sufficient to meet our capitalrequirements is a forward-looking statement that involves risks anduncertainties, and actual results may differ materially.  Our future liquidity and capital fundingrequirements will depend on numerous factors including, but not limited to,commercial success of our products, or lack thereof, of our current products,the extent to which our products under development are successfully developedand gain market acceptance, the timing of regulatory actions regarding ourpotential products, the costs and timing of expansion of sales, marketing andmanufacturing activities, prosecution and enforcement of patents important toour business and any litigation related thereto, the results of clinicaltrials, competitive developments, and our ability to maintain existing collaborationsand to enter into additional collaborative arrangements.  We have incurred negative cash flow fromoperations since inception and do not expect to generate positive cash flow tofund our operations for at least the next several years.  We may need to raise additional capital tofund our research and development programs, to scale-up manufacturingactivities and expand our sales and marketing efforts to support thecommercialization of our products under development.  Additional capital may not be available on terms acceptable tous, or at all. If adequate funds are not available, we may be required tocurtail our operations significantly or to obtain funds through entering intocollaborative agreements or other arrangements on unfavorable terms. Ourfailure to raise capital on acceptable terms when needed could have a materialadverse effect on our business, financial condition or results of operations.

 

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**Item3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

**Short-term investments**. We invest ourexcess cash in short-term, interest-bearing investment-grade securities thatprimarily are held for the duration of the term of the respective instrument.We have not utilized derivative financial instruments, derivative commodityinstruments or other market risk sensitive instruments, positions ortransactions in any material fashion. Accordingly, we believe that, while the instruments we hold are subjectto changes in the financial standing of the issuer of such securities, we arenot subject to any material risks arising from changes in interest rates,foreign currency exchange rates, commodity prices, equity prices or othermarket changes that affect market risk sensitive instruments.

 

**Foreign currency rate fluctuations**. Thefunctional currency for our Netherlands and German subsidiaries is the U.S.dollar and euro, respectively. The German subsidiary’s accounts are translatedfrom the euro to the U.S. dollar using the current exchange rate in effect atthe balance sheet date for balance sheet accounts, and using the averageexchange rate during the period for revenues and expense accounts. The effectsof translation are recorded in accumulated other comprehensive income in theconsolidated financial statements included herein. In certain instances, oursubsidiaries conduct business with customers and vendors in euros or in otherlocal European currencies. Exchange gains and losses arising from thesetransactions are recorded using the actual exchange rate differences on thedate of the transaction. We have not taken any action to reduce our exposure tochanges in foreign currency exchange rates, such as options or futurescontracts, with respect to transactions with our European customers and vendors.The net tangible assets of our subsidiaries, excluding intercompany balances,is $2.2 million at March 31, 2003.

 

**Item4.  Controls and Procedures**

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act Filings and Reports is recorded, processed, summarized andreported within the timelines specified in the Security and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, to allow timely disclosure.  In designing andevaluating the disclosure controls and procedures, management recognized thatany controls and procedures, no matter how well designed and operated, can onlyprovide reasonable assurance of achieving the desired control objectives.

 

Within 90 days prior to the date of this report, wecarried out an evaluation, under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures.  Based on the foregoing, our Chief ExecutiveOfficer and Chief Financial Officer concluded as of the date of theirevaluation, that our disclosure controls and procedures were effective.

 

There have been no significant changes in our internalcontrols or in other factors that could significantly affect these controlssubsequent to the date we carried out this evaluation.

 

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**PART II - OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

Please see discussion of legal proceedings at note 6in the Notes to the Consolidated Financial Statements included elsewhere inthis report.

 

**Item6.  Exhibits and Reports on Form 8-K**

 

(a)          Exhibits

 
| 99.1 | Chief  Executive Officer and Chief Financial Officer Certification Letters, dated  May 13, 2003 |
|------|-------------------------------------------------------------------------------------------------|

 

(b)         Reportson Form 8-K

 

There were no reports on Form 8-K filed during thethree months ended March 31, 2003.

 

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**NANOGEN, INC.**

 

##### **SIGNATURES**

 

**Pursuant to the requirements of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned thereunto duly authorized.**

 

 
|     |   |             | **NANOGEN, INC.**                    |
|----------|--------|------------------|--------------------------------------|
|     |   |             |                                 |
|     |   |             |                                 |
| **Date** |   | **May 13, 2003** |                                 | **/s/ Howard C.  Birndorf** |   |
|     |   |             | **Howard C.  Birndorf**              |
|     |   |             | **Executive  Chairman and Chief**    |
|     |   |             | **Executive  Officer**               |
|     |   |             | **Principal  Executive Officer)**    |
|     |   |             |                                 |
|     |   |             |                                 |
| **Date** |   | **May 13, 2003** |                                 | **/s/ Gerard A.  Wills** |   |
|     |   |             | **Gerard A.  Wills**                 |
|     |   |             | **Vice  President, Chief Financial** |
|     |   |             | **Officer and  Treasurer**           |
|     |   |             | **(Principal  Financial and**        |
|     |   |             | **Accounting  Officer)**             |

 

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**Chief Executive Officer Certification**

 

I, Howard C. Birndorf, Chairman of the Board and Executive Chairman ofNanogen, Inc. certify that:

 

(1)                                  Ihave reviewed this Quarterly Report on Form 10-Q of Nanogen, Inc. (the“registrant”);

 

(2)                                  Basedon my knowledge, this Quarterly Report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this QuarterlyReport;

 

(3)                                  Basedon my knowledge, the financial statements, and other financial informationincluded in this Quarterly Report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this Quarterly Report;

 

(4)                                  Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as such term is defined inExchange Act Rules 13a-14 and 15d-14) for the registrant and have:

 

(i)                                     designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this Quarterly Report is being prepared;

 

(ii)                                  evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this Quarterly Report (the“Evaluation Date”); and

 

(iii)                               presentedin this Quarterly Report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

(5)                                  Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee of theboard of directors (or persons fulfilling the equivalent function):

 

(i)                                     allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(ii)                                  anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

(6)                                  Theregistrant’s other certifying officers and I have indicated in this QuarterlyReport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Dated May 13, 2003                 |
|------------------------------------|
|                               |
|                               |
| /s/ Howard C. Birndorf             |   |
| Howard C. Birndorf                 |
| Chairman of the Board and          |
| Executive Chairman of Nanogen Inc. |
| (Principal Executive Officer)      |

 

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**ChiefFinancial Officer Certification**

 

I, Gerard A. Wills, Vice President, Chief Financial Officer andTreasurer of Nanogen, Inc. certify that:

 

(1)                                  Ihave reviewed this Quarterly Report on Form 10-Q of Nanogen, Inc. (the“registrant”);

 

(2)                                  Basedon my knowledge, this Quarterly Report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this QuarterlyReport;

 

(3)                                  Basedon my knowledge, the financial statements, and other financial informationincluded in this Quarterly Report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this Quarterly Report;

 

(4)                                  Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as such term is defined inExchange Act Rules 13a-14 and 15d-14) for the registrant and have:

 

(i)                                     designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this Quarterly Report is being prepared;

 

(ii)                                  evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this Quarterly Report (the“Evaluation Date”); and

 

(iii)                               presentedin this Quarterly Report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

(5)                                  Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee of theboard of directors (or persons fulfilling the equivalent function):

 

(ii)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(ii)                                  anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

(6)                                  Theregistrant’s other certifying officers and I have indicated in this QuarterlyReport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Dated May 13, 2003                           |
|----------------------------------------------|
|                                         |
|                                         |
| /s/ Gerard A. Wills                          |   |
| Gerard A. Wills                              |
| Vice President, Chief Financial Officer and  |
| Treasurer of Nanogen, Inc.                   |
| (Principal Financial and Accounting Officer) |

 

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**NANOGEN, INC.**

### **EXHIBIT INDEX**

 
| **Exhibit No.** |   | **Description**                                                                               |
|-----------------|--------|-----------------------------------------------------------------------------------------------|
| 99.1            |   | Chief Executive Officer and  Chief Financial Officer Certification Letter, dated May 13, 2003 |

 

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